After learning how to build a portfolio in Investing 101, we will now dive into some strategies we use at First Dakota Wealth & Trust to take advantage of the tax code through tax-advantaged accounts and other strategies to reduce your tax bill.
Read on to learn more about some strategies that can help you craft an intentional and strategic investment plan.
(Asset) Location, Location, Location
Not to be confused with asset allocation, asset location deals with where you strategically keep the money you’re investing. Generally, you can choose between tax-advantaged, tax-free, and taxable accounts.
Where you have your money will make a big difference come tax time. That’s because your investments, and the returns they accumulate, are taxed differently when coming out of different accounts.
Think of asset location as a three-bucket approach to taxation. The three buckets are assets that are taxable now, taxable later, and never taxable.
Taxable Brokerage Account (Taxable Now)
Standard taxable accounts do not provide any form of the tax shield. Interest and dividends received on investments held in taxable accounts are generally taxed as income in the year you receive them.
Capital gains, the return you make when your investments increase in value, are also taxed in the year you sell the investment. If you have held the investment for less than a year, a capital gain is taxed as income. Gains from investments held longer than a year are taxed at a lower rate.
Examples of taxable assets now are more liquid assets such as savings, checking, CDs, mutual funds, stocks, and rented real estate. The earnings on these assets are taxable annually. There are some investments in taxable accounts which receive preferential tax treatment, which will be discussed later in the article.
Tax-deferred (Taxable Later)
Money held in tax-deferred accounts like IRAs and 401ks are taxed as income when you withdraw them. Your investments are shielded from taxes along the way. If assets can be placed into tax-deferred vehicles, you can expect better compounding returns because the annual tax bill won’t erode your earnings.
The tax later options are often funded via pre-tax contributions to IRA's or workplace retirement accounts. A significant benefit to tax deferral is that your income tax bracket will likely be lower than it is while working. That means you’ll end up paying less in taxes on each dollar withdrawn.
Fixed or variable annuities and savings bonds may also grow in value tax-deferred even if they aren’t in a tax-deferred account.
A downside to tax deferral is that large distributions at one time from these assets can create a large tax bill. Often, you are forced to take distributions when you reach certain ages due to required minimum distribution rules.
Tax-free (Never Taxable)
The final category, and the most favored by many, is “tax never.”
A prevalent “tax-never” strategy is to fund Roth IRA's or Roth 401(k) with after-tax monies while working. Designated Roth accounts to trade the up-front tax deduction of tax-deferred accounts for tax-free withdrawals in retirement.
So, the accounts grow tax-free and can be withdrawn tax-free in retirement. Frequently, contributions to Roth accounts can be withdrawn penalty-free even before retirement if it is done correctly.
Another popular tax-free strategy is to buy municipal bonds. Interest payments received from municipal bonds are free from federal income tax. However, the interest rate on municipal bonds is often lower than comparable corporate bonds. Municipal bonds make more sense the higher your tax rate is.
HSAs (Triple Tax Advantage)
One of the best tax-advantaged strategies is a Health Savings Account. They have triple tax advantages, as the money invested is before tax, they grow tax-deferred, and they can be tax-free for qualified medical expenses.
Not everyone is eligible to contribute to an HSA. You must be covered by a healthcare plan that meets specific criteria to qualify. The main requirement is that your plan is a high-deductible healthcare plan or HDHP. If you are eligible to partake in an HSA, consider maximizing your annual contribution.
Where YOU should have your money depends on many factors. Take into account your financial profile, prevailing tax laws, and investment holding periods.
All of the tax-advantaged strategies have limitations or penalties associated with funding or misusing them. Consult with your tax advisor and financial advisor to make sure you have it right.
Tax Loss Harvesting
One available strategy for reducing the tax bill on your tax now accounts (with investments such as stocks and mutual funds) is tax-loss harvesting.
If you have a well-diversified portfolio, some of your investments will likely have positive appreciation over the long term, while others may experience a significant loss. It may be a good idea to sell the assets at a loss because you can use these losses to offset the capital gains of your better-performing investments.
This tact is usually done in December, so you can see what your other investments will do to the year's taxes. It must be completed before December 31 if you want it to count for the current year.
Tax-loss harvesting can be a critical strategy for those close to the next tax bracket, so you can keep from bumping into it.
Low-Cost Passive Income Investments
To round out your portfolio, build in some low-cost passive income investments such as:
Real Estate or REITs
Investing in real estate can add some diversification to your portfolio while also providing tax benefits. Real estate allows for depreciation offsets, and some income receives preferential tax treatment.
Many people don't have the desire or capital to invest in individual real estate holdings, but a viable option for many is Real Estate Investment Trusts. REITs invest in multiple properties and generate income from rent, dividends, and capital gains from property sales. The fact that there are three sources of income makes real estate investing popular.
Exchange-Traded Funds (ETFs)
ETFs are often structured so the capital gains generated by buying and selling within the fund aren’t reported as income.
This is unlike mutual funds, which must report capital gains every year.
If you have non-retirement accounts in your portfolio, discuss ETF's with your advisor to learn about their tax advantages over mutual funds.
Dividend-paying stocks
There is also potential tax efficiency with dividends paid by most US companies. When you invest in an individual stock, ETF's, or mutual funds that own stocks, you will often receive dividend payments.
Most dividends that you receive are classified as “qualified” as compared to “ordinary” dividends. The most significant difference between qualified and unqualified (ordinary) dividends is the rate at which these dividends are taxed.
Qualified dividends are taxed at lower rates—the same as capital gains from investments you held for longer than a year. Unqualified dividends do not receive special treatment and are taxed at the individual's standard tax rate.
Create An Investment Portfolio Unique To You
Asset location can play a significant role in determining your future tax bill. Different strategies are needed for different individuals depending on the amount and sources of income available.
It is necessary to have a discussion with your financial advisor about your current and future tax brackets. At First Dakota Wealth and Trust, we have financial planning software that updates with new tax policies when changes are made in Washington DC. The software can estimate your current and future tax bills and help us develop a plan that maximizes growth and minimizes taxes.
Contact us today to learn how we can help you.
Disclaimer
First Dakota Wealth & Trust is the fiduciary investment department of First Dakota National Bank with trustee powers to serve clients during their lifetime, during incapacity, and after death. We help clients develop a financial roadmap to help simplify their financial future.
Please note that neither First Dakota National Bank nor First Dakota Wealth & Trust Department or its employees provides tax or legal advice. This is intended for informational purposes and is not intended to constitute legal or tax advice. Please consult your attorney and/or tax professional for advice related to your specific situation.
