As a rule of thumb, the more income an investment generates, the higher the tax bill. But that doesn’t always have to be the case. In fact, there are several ways that cities, states and the IRS give investors to manage taxes.
Here, I’ll discuss ways to help manage the impact of taxes on various investments, and the asset classes or strategies that can enable improved returns.
Tax-Efficient Versus Inefficient Investments
It’s pretty easy to tell whether an investment is tax-efficient. When comparing different investments to one another, the one leaving the most after-tax returns in the bank relative to the size of the investment is typically the most tax-efficient. These factors can be considered by determining how the investment is utilizing the tax deductions the IRS has mandated. This isn’t a function of just the investment itself, but also how you’re utilizing the investment — whether you’re taking on debt or increasing your basis, among other considerations.
When thinking about the tax efficiency of an investment in your portfolio, there are a couple of considerations to be had:
1. Tax bracket: Tax-efficient investing is usually more important to taxpayers in the upper-income brackets, in my experience. For example, an investor paying a marginal tax rate of 10% or 12% receives less relative benefit than an investor in the 37% bracket.
2. Capital gain versus normal income: Taxes are usually applied at two different levels: capital gains and income. While capital gain taxes typically apply to investment appreciation and sale, income tax applies to whatever income that particular investment is generating. As an example, the taxes applied to a stock that is sold is different than the taxes on that stock’s dividends. Tax-efficient strategies can be applied to either and are dependent upon what you, the investor, are trying to achieve.
Are All Investments Taxed Equally?
When it comes to capital gains, investments generally fall into one of three tax categories: Tax-exempt or free, tax-deferred and taxable.
1. Tax-exempt: Tax-exempt investments, also known as tax-free investments, let you keep more of your hard-earned money. Popular tax-exempt investments include:
• Withdrawals from Roth individual retirement accounts, or IRAs, and Roth 401(k) plans.
• Health savings accounts, or HSAs, assuming the funds are used for qualified expenses.
• Municipal bonds — these are federal tax-exempt and can also be state tax-exempt; however, filers will still owe taxes with alternative minimum tax.
• 529 education funds, if used for qualified education expenses.
• U.S. savings bonds.
2. Tax-deferred: These investments allow earnings to accumulate with minimal tax ramifications until the investor begins making withdrawals or taking “constructive receipt” of the profits. Common tax-deferred investment vehicles include 401(k) plans and tax-deferred annuities.
Investments that are tax-deferred allow:
• Capital to accumulate without immediate tax ramifications.
• Tax return deductions for IRA and 401(k) plan contributions, as a result of lower taxable income.
• Money to be withdrawn at a lower tax bracket when the investor retires (if the tax rate is lower at that time).
• 1031 exchange, which is deferring the capital gains on your real estate sales by reinvesting in another property of equal value.
3. Taxable: Investments that generate ordinary income and are not funded using retirement accounts are considered taxable investments. Some examples include stocks and bonds (excluding most municipal bonds), certificates of deposit, money market accounts and recurring net income from real estate investment trusts and real estate.
Fortunately, there are ways to manage the taxes paid from a taxable investment. An article in U.S. News & World Report lists eight ways to manage taxes, including:
• Using tax-loss harvesting to reduce taxable income.
• Putting “aggressive” investments that may generate a loss in a taxable account to capture the tax benefits of any loss.
• Avoiding short-term capital gains tax by minimizing investment turnover.
Tax Benefits Of Real Estate Investing
Long-term capital gains generated from the sale of stocks and real estate are also taxable. However, the real estate-friendly tax laws in the U.S. offer investors several ways to reduce taxable income and defer paying tax on capital gains when an asset is sold — perhaps more so than any other asset class.
• Deduction of normal business expenses, such as an office, and time spent managing the property and showing to tenants, to reduce taxable net operating income.
• Mortgage interest deductions from gross operating income.
• Depreciation expense for the property is a non-cash deduction from income and is one method real estate investors use to minimize the amount of taxable income reported while having plenty of cash flow.
• IRS Section 1031 tax-deferred exchange is used to sell one investment property and buy another, defer the tax owed on a realized capital gain and use that extra money to invest in more real estate.
Other tools to improve returns include:
• Timing a sale by understanding the difference between short-term and long-term gains.
• Tax losses from the sale of one asset to offset the payable tax on another.
• Tax-loss carry-forward allows a taxpayer to carry a tax loss to future years and reduce future tax payments.
• Charitable contributions to qualified organizations can be used to deduct up to 50% of a taxpayer’s adjusted gross income provided the tax return is itemized.
Investment tax law can be confusing for even the most experienced investors. That’s why it’s important to work with a CPA or tax professional, who can help you understand each asset class and influence wise decisions around your individual situation. These tax and investment professionals have the experience to help place you in the ideal tax scenario for your needs and preferences.
Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.