Think you paid too much tax on your investment income this season? Consider these moves today to create less pain for 2017.
Buy low turnover funds
Active mutual funds are run by managers who buy and sell stocks regularly. Some active funds turn into downright tax traps where you can lose money and owe taxes because of the capital gains that result from the trading the manager has done with the shares you hold in the fund. The way to avoid that problem is to chose funds that use a buy-and-hold approach, which is the way index funds work. The Vanguard Total Stock index fund has virtually no turnover within the fund and thus generates little capital gains tax obligations, other than those you would incur when you actually sell your shares.
Get your asset allocation right
After selecting an asset allocation that's right for you (stocks, bonds and cash), place the assets where they are more tax efficient. Investments taxed at the highest rates belong in tax-deferred accounts such as IRAs, 401(k)s or 403(b)s, even in tax-free Roth accounts. Those assets include taxable bonds, certificates of deposit and real estate investment trusts (REITs). More tax-efficient investments, such as broad stock index funds, belong in taxable accounts. If you want to buy individual stocks and hold them for many years, taxable accounts are fine. Even an active stock fund that has low turnover (say, sells less than 10 percent of its holdings annually) can be tax efficient in your taxable account. That's because dividends are currently taxed at a 15 percent rate (unless your income is very high), and the capital gains can be deferred by holding the investments.
Harvest your tax losses
Tax-loss harvesting is key to tax-efficient investing. This means you sell taxable investments if you have losses in order to save in taxes. You can use the losses to offset any gains you have, plus use up to $3,000 of losses to offset taxes on your ordinary income, such as salary.
During the stock market meltdown in 2008 and 2009, I was selling my stock index funds even as I was buying slightly different ones. The reason I did so was to comply with the IRS' so-called wash sale rule, which states that you can't buy back the same fund within 30 days — so you have to buy something different to stay in the market.
In the world of indexing, for example, if you own the Vanguard Total International Index Fund at a loss, you could buy the iShares Core MSCI Total International Fund, which is very similar to the Vanguard fund you sold.
When it comes to losses, it needn't be a total loss — make the best of it.
Summing it up
Taxes are costs, too, and so by investing more tax efficiently, you'll add to your net returns. I regularly remind clients that their goal is not to minimize taxes but, rather, to maximize what they keep after paying them.
Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.