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Home›Investment Management›5 Tips for Tax-Efficient Portfolio Management

5 Tips for Tax-Efficient Portfolio Management

By WiserAdvisor Insights
January 6, 2020
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Last Modified on January 17, 2020

When it comes to an investment portfolio, risk and return are the two primary factors that you need to consider However, in addition to these, another important factor that is worth considering is tax. 

Taxes cut into the returns that are received on your investments. So, it is imperative to pursue tax efficiency in any investment portfolio where taxes play a part. Tax efficiency can help maximize your investment returns and minimize your overall tax burden. 

Moreover, investing in a tax-efficient manner doesn’t need to be too complicated. However, it does require some planning from you. By keeping a few general tips on your mind when considering varied investment options, you can significantly reduce the amount of taxes that you pay on them.

Table of Contents

  • Tips for Tax-Efficient Portfolio Management
    • 1. Understand Taxable, Tax-Deferred and Tax-Exempt Accounts
    • 2. Know Your Tax Bracket
    • 3. Invest in Tax-Efficient Options
    • 4. Avoid Tax-Inefficient Investments
    • 5. Leverage the Benefits of Tax-Deferred Accounts
  • To sum it up

Tips for Tax-Efficient Portfolio Management

While an efficient tax strategy should ideally be tailored to an individual’s personal circumstances, certain generalities hold true for all kinds of portfolios. Here are some valuable tips towards tax-efficient portfolio management:

1. Understand Taxable, Tax-Deferred and Tax-Exempt Accounts

The first step towards building a tax-efficient portfolio is to understand the difference between taxable, tax-deferred and tax-exempt accounts. Once you have this knowledge, you can make more educated investment decisions and pay lesser taxes on the investments that you opt for. Generally, it is advised that you place your tax-efficient investments in a taxable account, whereas tax-inefficient investments should be placed in a tax-deferred account.

The investments that you place in a taxable account are taxed on prevailing rates and there are no exemptions in almost all cases. Taxable accounts include bank accounts, investment accounts and money market mutual funds. 

If you place your investment in a tax-deferred account, the income it generates remains sheltered from taxation as long as it remains in the account. The two most commonly used tax-deferred accounts are traditional IRAs and 401(k) accounts. 

Investments such as municipal bonds are considered to be tax-exempt accounts. You need not pay any federal taxes on a tax-exempt account even when you withdraw money from it.

2. Know Your Tax Bracket

The Internal Revenue Service (IRS) taxes investment incomes differently based on your tax bracket. Hence, it is crucial to know which bracket you fall under. By knowing your tax bracket, you are better prepared to plan investments in a manner that maximizes returns while minimizing tax liability. This information can also help identify what types of investment opportunities are the most beneficial for you.  

It becomes even more important for individuals falling under a high marginal bracket rate to plan their investments in a tax-efficient manner. For instance, the benefits that can be received form tax-efficient investing are significantly more pronounced for someone in the highest 37% bracket as compared to someone in the 10% or 12% bracket. Moreover, investors falling under the high-income bracket should also know whether the alternative minimum tax (ATM) applies in their case. 

3. Invest in Tax-Efficient Options

Some investment options are more tax-efficient than others. Your aim should be to capitalize on such tax-efficient investments. Common stocks are considered to be one of the most tax-efficient investments that you can make. When held in tax-deferred accounts, high-dividend stocks are subject to minimal taxes. Investment-grade corporate bonds are another type of investment that can help lower your tax profile. As with common stocks you can put them in a tax-deferred account. 

If you belong to the high-income tax bracket, municipal bonds are worth considering too. The income earned from municipal bonds is generally exempt from federal taxes, thus making them the most tax-efficient of all bonds. They may yield lower returns than other investment-grade, corporate bonds but you can hold them in a taxable account. Some other tax-efficient investments include index funds, exchange-traded funds and tax-managed mutual funds with low turnover.

4. Avoid Tax-Inefficient Investments

You should steer clear of tax-inefficient investments such as junk bonds and straight-preferred stocks. Junk bonds, also known as high-yield bonds, are low-quality bonds that usually pay higher returns as compared to other high-quality bonds. Junk bonds may seem like an attractive option, but they are highly speculative investments that are taxed at the same rate as ordinary income.

Straight-preferred stocks, on the other hand, are hybrid investments that have the characteristics of both bonds and stocks. For instance, they are issued in perpetuity, just like commons stocks are. However, they yield fixed payments like ordinary bonds. The problem is that the income you earn from such bonds is also taxed as ordinary income, thereby making them quite tax-inefficient.

5. Leverage the Benefits of Tax-Deferred Accounts

In case you are still interested in tax-inefficient investments because of the high returns that they can provide, remember to place them in tax-deferred accounts. So, investments such as high-yield bonds, actively-traded mutual funds and high-dividend stocks should be placed in a tax-deferred account. All of these investments usually generate a high amount of income that is taxed as ordinary income unless placed in a tax-deferred account. 

Many Americans love to deal in IRAs and 401(k)s and there’s a good reason for this – no taxes are owed on the trades that they make. All gains on such investments are deferred into their retirement accounts. This is a huge benefit that can enable you to reinvest money towards the increased growth of your investment portfolio.

To sum it up

Taxes can significantly reduce the returns that you receive on your investments and this can potentially jeopardize your long-term goals. In all effectiveness, you can minimize the tax deductions on your investments by managing your portfolio in a tax-efficient manner. Tax-efficient portfolio management does require due diligence on your part. However, the monetary benefits that it provides far outweigh the work that you need to put in.  

Taxation rules and rates might keep changing in the United States of America, but the value of tax-efficient portfolio management will always remain intact.

If you want any kind of assistance in building a tax-efficient investment portfolio, you can get in touch with top financial advisors today.

Tagsfinancial planningInvestmentpersonal financePortfolio ManagementWealth
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A team of dedicated writers, editors and finance specialists sharing their insights, expertise and industry knowledge to help individuals live their best financial life and reach their personal financial goals. We believe that there is no place for fear in anyone's financial future and that each individual should have easy access to credible financial advice.

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