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Many DIY (do it yourself) investors don’t account for taxes adequately.
They often engage in short-term trading which increases their taxable income.
Even worse, some fail to properly use tax shelters like IRAs and 529 plans.
A combination of such actions can take a 30%+ dent out of long-term savings.
The intent here is to provide a concise list of items that could significantly improve your net, after-tax gains.
This is by no means comprehensive—many important considerations about insurance and inheritance are not touched here.
If you’re dealing with a lot of money, it may make sense to consult with an expert on this subject.
Without further ado, below are important facts to keep in mind.
- Don’t ignore the power of tax-advantaged accounts.
Purchasing securities within a traditional 401k or IRA reduces your ordinary income by the amount directed to this account.
This can substantially increase your net worth long term.
Likewise, if you’re saving money for a kids tuition you may be able to grow it tax free within a
529 plan.
- For most securities (stocks, ETFs, mutual funds, bonds) selling within a year of purchase is deemed a “short-term” transaction.
If you sell for a gain, the gain will be taxed as ordinary income,
which will often cause you to pay significantly more tax than long-term capital gains sold more than a year after purchase.
- Interest payments for bonds are taxed as ordinary income, which is generally greater than long-term capital gains.
If you plan to hold a lot of bonds over the long-run, it’s more efficient to keep them in a tax-advantaged account like a 401k/IRA to dodge this penalty.
- Real estate investment trusts (REITs) pay at least 90% of their taxable income to shareholders as dividends.
These dividends are mostly taxed higher than other investment gains (they’re taxed as ordinary income).
Holding REITs within an IRA or 529 dodges this penalty.
- Gold and bullion, including ETFs holding gold/bullion, like IAU, are taxed at a higher rate than normal capital gains.
This is true even when held for over a year.
If you plan to hold bullion long-term, it’s more efficient to hold it in a 401k or IRA where you won’t be required to pay the extra penalty.
- Planning to make a charitable donation?
You may want to donate your most appreciated assets rather than cash.
When you sell an asset, capital gains tax will eat a chunk of your profit.
If you donate the asset, both you and the beneficiary incur no tax!
- Consider tax-loss harvesting. Capital losses offset capital gains—if you earned $1000 on one investment you sold in
January, and are $1000 down on another investment in December, you can often sell the 2nd investment to avoid taxes on the 1st.
You can immediately re-invest the capital from the second investment into something else, as long as it’s not “substantially identical.”
ETFs, even reflecting the same index, have not been ruled substantially identical.
You can literally sell SPY and buy VOO to reduce taxes without really changing your portfolio.
- Interest on municipal bonds (also called munis) is typically exempt from federal taxes.
The market is efficient in that the interest rates on these bonds are lower (per unit risk) to account for this advantage.
However, if you’re in a high tax bracket and need to hold bonds outside a tax-advantaged account,
munis will likely offer a better return net of taxes. It almost never makes sense to hold munis in an
IRA—you’ll get a lower rate than on other bonds, and you’ll have to pay income tax on the withdrawals.
- International, ex-US stocks typically pay higher dividends than US stocks.
These dividends are often taxed by the country in which the business resides;
a tax that may be subtracted from your return/dividend (even if you’re using a tax-advantaged account).
In the US, if you hold these shares in a taxable account you can receive a tax credit for foreign taxes paid.
You will however, still owe US tax on the dividends, regardless of where the business is located.
Exactly how all this impacts you depends on your specific scenario.
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