Take control of your taxes: Three tenets for tax-aware investing
Eaton Vance Advisor Institute04/06/22
Summary: When it comes to tax planning, it’s helpful to think ahead. Learn three guiding principles for investors.
Taxes can be confusing no matter our income level. There are multiple tax filing categories, income brackets and tax rates, and additional taxes that kick in at different thresholds.
When considering the impact of taxes on investments, it is important to understand the different tax treatment for specific types of accounts.
- Taxable brokerage accounts: Individual investments are taxable and subject to a wide range of taxes. Taxes can be assessed annually (which is usually the case for investment income, like dividends or interest) or by event (such as when an investment is sold or a benefit is received).
- Tax-deferred accounts: Retirement accounts, such as traditional IRAs and 401(k) plans, permit contribution of pre-tax dollars, and there is no tax on the growth, if any, from one year to the next. Instead, investors are generally subject to taxes when money is withdrawn in the future.1,2
- Special retirement accounts: These include Roth IRAs and Roth 401(k) plans, which allow after-tax contributions. As a result, no taxes are paid on the growth, if any, of those investments and all future withdrawals, assuming all requirements are met (e.g., account has been open at least five years and account owner is at least 59 1/2 years old).
Tax planning is not just a tax-season or year-end activity. It should be a factor in decision-making 365 days a year. Let’s review three simple tax tenets that can help investors navigate these often complex decisions.
1. Uncle Sam can be a coach, not just a referee
A coach trains players to play the game in the best way possible, while a referee points out fouls and penalties. Seeing Uncle Sam as a coach requires recognizing the tax code for what it is: a long list of “carrots” and “sticks” to encourage some behaviors and discourage others.
Collecting more carrots can optimize tax outcomes, while avoiding being hit by the sticks. With Uncle Sam as a coach, along with a tax professional, investors can simply let the tax code be their guide to figuring out which shares of stock to sell first, which shares to keep for decades, and which shares fall somewhere in between based on how and when they are taxed.
For example, shares purchased with pre-tax dollars, such as those in employer-sponsored retirement plans, can grow tax-deferred within the account. This may result in large amounts of highly appreciated stock held in a portfolio for years, and that appreciation is not taxed during the accumulation phase. Qualified withdrawals in retirement are subject to ordinary income tax, likely at a lower tax rate than during employment years.
In brokerage accounts, shares that are sold and which were held longer than one year are generally taxed at long-term capital gains rates, which are currently lower than short-term rates. So rising shares held longer than a year would be subject to a lower capital gains tax rate when sold, and declining shares held a year or less could provide a more valuable short-term tax loss when sold.
And what about those losses? Most people react negatively to the word “loss.” But tax losses can actually be of value to an investor. Money lost on an investment—and let’s face it, nobody gets every investment choice right 100% of the time—can be used to help reduce the amount of taxes paid for gains elsewhere in an investment portfolio. A “realized” loss or gain is a loss or gain that happens when an investment is sold.
2. Asset location can be as important as asset allocation
Choosing the right investments at the right time can make a difference in investment returns. While asset allocation decisions may account for the majority of investment returns, asset location will strongly influence what remains after taxes.
Asset location matters because a single investment can produce a different tax experience depending on the kind of account it is held in—tax-deferred, tax-free, and taxable accounts.
Rebalancing a portfolio can also benefit from good asset location. Location decisions can affect the return experienced after fees and after taxes.
3. Taxes can be one of the easiest investment “fees” to reduce
The tax "fee" can be much larger and easier to reduce than other investment-related fees. For example, if an investor holds shares that have risen in value, when those shares are sold impacts the tax rate for the gain.
Selling before the first anniversary of ownership—that is, selling in less than a year—will generate short-term capital gains tax (assuming no tax losses elsewhere in the portfolio or carried forward from previous years). What looked like a 25% pre-tax return can become a little more than a 15% return after taxes, assuming that the 37% tax rate applies.
Another way to look at it is to consider taxes as any other investment fee—typically expressed in basis points. One basis point is equal to 1/100th of 1 percent. Thinking of taxes this way—as a fee—is important because making slightly different choices can make a material difference in your investment experience and potentially reduce tax “fees.”
It’s easy to believe we have no control over taxes whatsoever. However, the simple fact is by understanding a few important tax basics, investors can make better decisions for their overall portfolio.
- Withdrawals from IRAs are generally taxed as ordinary income (with the exception of Roth IRAs). Withdrawals prior to age 59 1/2 are subject to a 10% tax penalty.
- Certain investments held in retirement accounts such as publicly traded partnerships may generate “unrelated business income” that can require the filing of Form 990-T and payment of taxes due by the account. Investors holding these investments in a retirement account should discuss this with a tax and/or financial advisor to determine the suitability of holding these investments in a retirement account.
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