It is not just what you earn but what you keep. Your portfolio’s gross investment returns mean less than your net return—what you keep after taxes. With careful planning and strategic execution, investors can minimize their tax liabilities and maximize after-tax returns to keep more of their hard-earned money.
Tax-loss harvesting: Turning losses into gains
Tax-loss harvesting involves selling investments at a loss to offset capital gains taxes. By realizing losses, investors can reduce their taxable income, effectively lowering their tax bill.
Suppose you have a stock that has decreased in value since purchase. By selling this stock, you realize a capital loss; this loss can be used to offset capital gains from other investments. If your losses exceed your gains, up to $3,000 can be deducted against your ordinary income annually, with any remaining losses carried forward to future tax years.
This strategy is particularly effective in volatile markets where asset values fluctuate. However, investors must be cautious of the “wash-sale rule,” which disallows tax savings if the investor prohibits repurchases of the same or a “substantially identical” security within 30 days before or after the sale.
Make gains long term
Gains made from selling assets held for one year or less are called short-term capital gains and are typically taxed at the same rate as ordinary income, which can be as high as 37 percent.
Holding assets for more than one year qualifies gains as long term, which are taxed at preferential rates. Short-term gains are taxed as ordinary income. A short-term capital gains rate of zero percent applies if your income is less than or equal to $89,250. The capital gains rate is 15 percent if your income is above that but less than or equal to $553,850. However, the capital gains rate increases to 20 percent if your income is above that threshold. Strategic timing of sales can optimize tax outcomes.
Tax-gain harvesting: Leveraging lower tax brackets
While it may seem counterintuitive, selling investments at a gain can be beneficial, especially when you are in a lower tax bracket and expecting a temporary or permanent increase of income (see above short-term capital gains rates at different income levels).
If an investor expects to be in a higher tax bracket in the future—perhaps due to anticipated income increases, changes in tax law, or the sale of a business, which may include income—it may be advantageous to realize gains now at a lower tax rate.
Asset location: Placing investments in the right accounts
Investors have access to different types of accounts. A couple of popular ones are “IRAs” or Individual Retirement Accounts and “brokerage” accounts; there are also “Roth IRAs.” These types of accounts are classified as follows for tax purposes:
- Taxable accounts (brokerage, trust, joint): Investments are subject to capital gains and dividend taxes annually.
- Tax-deferred accounts (401(k), traditional IRA): Contributions reduce taxes in the year made; gains and income taxes are deferred until withdrawal, typically during retirement.
- Tax-exempt accounts (Roth 401(k), Roth IRA): Contributions are made with after-tax dollars, but withdrawals are tax-free.
Asset location is about strategically placing investments across taxable, tax-deferred, and tax-exempt accounts to avoid as many taxes as possible. For example, tax-efficient investments like index funds and growth stocks that generate minimal annual taxable income are best held in taxable accounts. Tax-inefficient investments, such as bonds, REITs, and actively managed funds, which generate regular income, are better suited for tax-deferred accounts to defer taxes until retirement.
By aligning investments with the appropriate account type, investors can minimize taxes on investment income and gains.
Qualified charitable distributions from IRAs
For investors aged 70 years and six months or older, qualified charitable distributions (QCDs) allow direct transfers from an IRA to a qualified charity, satisfying RMD requirements without increasing taxable income. The distribution is excluded from taxable income, which can have additional benefits, such as reducing Medicare premiums and taxes on Social Security benefits. QCDs count toward the annual RMD, providing a tax-efficient way to meet withdrawal requirements.
Donor-advised funds: Maximizing charitable impact and tax deductions
Donor-advised funds (DAFs) allow investors to make a charitable contribution, receive an immediate tax deduction, and then recommend grants to charities over time. An investor donates cash or appreciated assets to a DAF. The contribution is eligible for an immediate tax deduction. The donated assets can be invested within the DAF, potentially growing tax free until grants are made to selected charities.
This tactic works if you already intend to give money to your favorite charity over time. It is most beneficial to charitably inclined investors during the years in which they are going to receive a monetary windfall. It is also an excellent way to fund charitable giving while avoiding capital gains taxes on appreciated assets.
Income shifting: Leveraging family tax brackets
Income shifting involves transferring income from a high-tax-rate individual to a lower-tax-rate family member.
- Gifting assets: Parents can gift income-producing assets to children who are in a lower tax bracket. However, the “kiddie tax” rules apply to unearned income for children under certain ages, taxing it at the parent’s rate beyond a threshold.
- Employing family members: Business owners can employ family members, providing them with earned income taxed at their lower rates while also benefiting from business expense deductions.
Maximizing contributions to tax-advantaged accounts
Contributing to tax-advantaged accounts reduces taxable income and provides tax-deferred or tax-free growth.
- 401(k) and traditional IRA: Contributions are pre-tax, lowering taxable income. Investments grow tax-deferred until withdrawal.
- Roth IRA and Roth 401(k): Contributions are after tax, but qualified withdrawals are tax free.
- Health Savings Account (HSA): Offers triple tax benefits—contributions are pre-tax, investments grow tax free, and withdrawals for qualified medical expenses are tax free.
The IRS sets annual contribution limits for each of these account types. Individuals aged 50 or older can make additional “catch-up” contributions, increasing their tax-advantaged savings potential.
Roth IRA conversions: Planning for future tax savings
A Roth IRA conversion involves moving assets from a traditional IRA or 401(k) into a Roth IRA, paying taxes now in exchange for tax-free withdrawals later.
Unlike traditional IRAs, Roth IRAs are not subject to RMDs during the owner’s lifetime. Roth conversions are advantageous when an investor expects to be in a higher tax bracket in retirement. Roth conversions often make sense during years with lower income, minimizing the immediate tax impact. It is also timely to do this when the market is down considerably so that a traditional IRA’s value is lower.
The importance of personalized tax planning
Tax mitigation is a critical component of investment strategy. By implementing these tactics, investors could significantly enhance their after-tax returns. However, tax laws are complex and constantly changing, so what works for one investor may not be suitable for another. Personalized planning ensures compliance with IRS regulations while optimizing tax outcomes.
Thoughtful tax planning is nearly as crucial as making sound investment choices in pursuit of wealth accumulation. By proactively managing tax liabilities, investors can keep more of their returns, ensuring their financial goals are met more efficiently.
Allen Harris is an owner of Berkshire Money Management in Great Barrington and Dalton, managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
