Once and a while when meeting with clients the question comes up, “So, where is the market headed?” Although I would love to look at my crystal ball and answer with sickening accuracy, investors understand that we cannot control the ups and downs of the markets. With that in mind, I try and educate them on the many ways they can control the odds of reaching their financial goals.
As an investor, one significant way to help your bottom line is by being tax-smart. That means seeking to maximize what you keep after taxes without taking any unnecessary risks. The payoff can be sizable. Being tax-efficient has the potential to boost your return significantly over the long term, all other factors being equal.
Let’s start with one of the most powerful things you can do to maximize the chances of helping your after-tax returns. If your employer offers a retirement account, such as a 401(k) or 403(b) plan, you should consider investing as much as you can in the plan. This is especially important if your employer matches any part of your contribution to the plan. That employer match represents an immediate increase to your contribution. Also, consider contributing on your own to a Roth IRA where your money can grow tax-free or a traditional IRA where it can grow tax-deferred.
Next, you may find it beneficial to your bottom line by using different types of funds for your taxable versus your tax-deferred accounts. For example, broad-based stock index funds, tax-managed funds, and municipal bond funds often have some tax advantages that typically work better in taxable accounts. Funds that have the potential to pay out more in taxable distributions, such as actively managed stock funds that may generate higher distributions of dividends and capital gains, often work better in a tax-deferred account. The same is true for taxable bond funds. Holding these investments in a tax-advantaged account allows you to reinvest distributions without paying taxes on them when you receive them.
This kind of smart asset location can also help keep more of your returns after taxes over the long term. For your taxable accounts, you can still reduce the potential tax bill on your investments if you look for funds with certain characteristics. For example, a stock fund that doesn’t buy and sell stocks too frequently, such as an index fund, is less likely to realize and distribute capital gains. Lower distributions can mean a lower tax bill for you.
Besides picking tax-efficient investments, there are other things you can do to reduce taxes on your investments. For example, if you don’t buy and sell too often in taxable accounts, you lower the risk of realizing profits that are subject to capital gains taxes. As long as you buy and hold an investment, you generally won’t have to pay taxes on its rising value.
So, to wrap up, remember these three keys to seeking higher after-tax returns. First, and most important, consider investing as much as you can in tax-deferred accounts. If you have extra money to invest, the next most important thing you can do is consider funds with lower distributions for your taxable accounts. And, finally, be tax-efficient yourself by avoiding too much trading activity. Of course, everyone’s situation is different and tax laws may change, so you should consult your tax advisor.