No one enjoys paying taxes. For some investors, minimizing taxes is their utmost concern. While it is never a bad thing to want to minimize the taxes you pay, investors should be more focused on maximizing their after-tax returns instead.
While these two concepts seem as though they are the same thing, they are not. For example, let’s say your taxable income is subject to a low marginal tax rate. If you invest in municipal bonds, you may not owe any taxes on the investment income you receive. However, you may find that you could earn a higher after-tax return from investing in a similarly positioned taxable bond fund even though you would pay federal tax on the investment income.
When it comes to investing for after-tax returns, there are three strategies you should employ:
Investing in tax-advantaged accounts is the best way for the majority of investors to maximize their after-tax returns. These types of accounts include 401(k) plans, Roth and Traditional IRA’s and 529 college saving plans.
Be certain to pay attention where you place your investments. For many investors, taxable bond funds are best used in tax-advantaged accounts that shelter their high income which is taxed at your highest tax rate. On the other hand, municipal bond funds are best placed in taxable accounts because of their favorable tax treatment.
Equity investments are better in taxable accounts because they have minimal dividend distributions and capital gains that are often taxed at the capital gains rate which is currently a maximum of 15%.
Using tax-advantaged accounts to rebalance or sell appreciated positions may provide for better after-tax returns because you would not realize capital gains, unlike in a taxable account where you would owe taxes on those gains. Additionally, there are times when realizing a loss in your taxable account is a good thing. Doing so can lower your taxable income or offset gains in other parts of your portfolio.
Using these strategies along with a well-diversified long term investment plan will help you to reach your goals.
Please note that the tax rates referenced above are subject to change and you should consult your tax advisor to discuss your individual situation.