I covered a lot of information last week in how to understand your tax reality and hope you were able to digest it all. My goal with every post I write is to deliver immense value, but I also don’t want to overwhelm you! Instead, I want to empower you to make good decisions around taxes. Therefore, I’m going to keep my ongoing posts on taxes a bit shorter and more succinct. Today, I’m going to discuss investment tax strategies, specifically asset allocation and harvesting losses.
The #1 Investment Tax Mistake
My first rule is you MUST know what you own and why. I have said this repeatedly, but this is one of the greatest mistakes people make with their investments. They don’t know what they own or why AND don’t understand how it is taxed. A solid investment strategy takes all three into consideration because picking whichever investment has the best return is not an investment strategy.
Disclosure: These strategies will not all be relevant to your personal situation and should be discussed with your CPA and financial advisor prior to implementation.
The Phantom Tax Impact on Investments
We discussed phantom tax last week but to quickly recap — phantom income is the taxable income from a mutural fund or other investments that you have not sold. A high performing fund manager is concerned with getting the highest returns. They are not concerned about the tax impact to you or your tax bracket. This is especially frustrating for investors during a bear or down market. Can you imagine a big tax bill the same year that your account lost money? Trust me, it happens!
How Asset Allocation Can Help Build a Tax Efficient Portfolio
Let’s take a closer look at how we can build a tax efficient portfolio through asset allocation.
What is Asset Allocation?
We’ve all heard the phrase “don’t put all your eggs in one basket” and that is what asset allocation is at its most basic form. It is the apportioning of investment funds across the categories of assets. This includes cash equivalents, stock, fixed income investments and tangible assets, including real estate, precious metals and collectibles. It also applies to sub-categories in bonds and stocks. Asset allocation affects both risk and returns and is a deliberate and thoughtful approach to selecting investments based on your risk tolerance, timeframe, goals and tax liability. It is not randomly selecting different investments.
Utilize Non-Qualified and Qualified Investments to Your Advantage
When it comes to taxes, there are Qualified Investments (tax-deferred) and Non-Qualified Investments (currently taxable). It is the Non-Qualified Investments that surprise investors with phantom income for current taxation. This why it is so important to know what you own. When you understand how your investments are taxed, you can then build a strategy around them to your advantage. Let me show you one possible strategy.
A Hypothetical Retirement Portfolio
This is a hypothetical investment portfolio for a married couple.
- $350k in a 401k’s (Qualified or tax-deferred)
- $100k in an IRA’s (Qualified or tax-deferred)
- $75k in savings account at the bank (Non-Qualified or currently taxable)
- $140k in investment account with an investment firm (Non-Qualified or currently taxable)
The mistake I regularly see many make is they used their non-qualified investment accounts for their higher performing investments and end up with an unexpected tax bill. This happens when you look at each investment as separate. Many couples forget to look at all of their 401k’s and IRA’s together. You should consider all the money for retirement as one portfolio. I would encourage you to consider using high-performing or non-tax-efficient investments in your Qualified Plans, then balance the allocation in your Non Qualified Plan to build a tax efficient portfolio.
Please Note: When building your portfolio for retirement, you need to consider your desired timeframe and risk tolerance as you select investments and create your asset allocation. Do not just consider taxes.
For the cash, you can consider tax-free investment, such as municipal bonds. But do the MATH first. Depending on your tax bracket, it may make more sense to pay the taxes and possibly yield a higher return in another investment.
The Bottom Line: Understand your allocation as it relates to the potential current taxation of your accounts.
Shannon’s Tax Break Tip
Keep in mind that paying taxes is not always a bad thing. I have seen many investors make decisions that were not in their best interest, just to avoid a fee or taxes. Do not make a knee-jerk reaction because you dislike paying taxes. If you know your investments and goals, you can do the math and make an informed decision.
How To Harvest Tax Losses/Gains
There is nothing investors dread more than seeing loss in their portfolio, even though we all should (hopefully) be prepared to handle market volatility. Still, it can be gut-wrenching, which can lead to emotional decisions that do more harm than good. Trust me, I understand. I don’t like seeing loss in my investment portfolio either. But there is a silver lining too. I have taught myself (and my clients) to ask themselves, “How can I take advantage of this?” which places you in a position of power and control, rather than panic.
Again, in order to get to that place, you must understand your portfolio and investments. There are so many mutual funds, ETF and stock choices available. If you have a loss in one asset class, many times you can sell to solidify the loss, then re-buy a similar (but not equivalent) asset. By doing this, you may be able to create Long Term Capital losses that you can carry forward to the years where you have capital gains. In good years, you can use these losses to offset those gains. This is called tax harvesting and is one reason I like pull backs in the markets.
DISCLOSURE: You should work with your financial advisor to understand the advantages and rules around harvesting loss, including the Thirty Day Wash Rule. Your financial advisor and CPA can help you build an appropriate strategy on how to take advantage of loss in your portfolio based on your personal situation.
Up Next: Retirement Plans
Next Monday, I’ll take a look at retirement plans at work and for the small business owner.
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