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You May Be Diversified, But Are You Tax Efficient?

Posted by Bill Hufnell, CPA, CFP® on February 06, 2019

Earning a solid return on your investments is certainly important, but it’s not what you earn that counts; it’s what you get to keep – the amount after the tax bite.

One important yet often overlooked benefit of effective wealth management is the strategic placement of your assets in order to minimize the taxes that you pay. While the difference may not seem that significant in the short term, it definitely adds up over time. As an example, let’s look at a 50-year old in the highest tax bracket with a $3 million portfolio and a 60% equity/40% bond asset allocation. Properly positioning this portfolio between tax-sheltered and taxable accounts can save an average of $35,000 a year in taxes compared to a similar portfolio that is improperly positioned. Over twenty years, the tax- efficient portfolio will grow by $1.2 million more than the inefficient portfolio.

The adept tax-advantaged allocation of your assets is a key behind-the-scenes benefit that Bay Point provides.

Here’s the process we go through to make sure you minimize the taxes on your investments:

Logical Positioning of Assets

Most investors need a diversified portfolio of both equities (stocks, stock mutual funds) and income producing investments (bonds, REITs). These types of investments receive different tax treatment. In general, bonds, REITs, CDs, and other income producing assets generate income that is taxed at your ordinary income tax rate, which can be as high as 39.6%, whereas equities that generate qualified dividends and long-term capital gains are taxed at a maximum rate of 20%.

In addition, most investors have a mix of taxable accounts (investment, bank and money market accounts) and tax-sheltered accounts (401(k)’s IRAs).

Whenever possible, we try to put your least tax-efficient assets, such as bonds or REITs, into tax-sheltered accounts, and your tax-efficient assets, such as stock funds into your taxable accounts.

This allocation strategy has several benefits:

  • Defer ordinary income - The capital gains that accumulate in your stocks and stock mutual funds are not taxed until you sell the investment. However, income produced by bonds and REITs is typically taxed in the year that it is earned. Placing these income investments into your tax-sheltered accounts, allows you to defer taxation until you make distributions.
  • Take advantage of preferential tax treatment - Distributions from tax-deferred accounts are always taxed at your ordinary income tax rate regardless of how the income was generated. When you hold equities in your IRA, the long-term capital gains and qualified dividends they generate are essentially converted to ordinary income upon distribution, losing their preferential tax treatment. Whereas, holding these securities in taxable accounts allows you to take advantage of the lower tax treatment
  • Harvest losses - Holding stock investments in a taxable account allows you to take advantage of market downturns by harvesting losses to reduce taxes. When you sell a loss in a tax-sheltered account, you receive no tax benefit.
  • Donate appreciated securities - If you plan to donate money to a charity, you can avoid taxes on your gains by donating your stocks or funds directly to the charity.
  • Receive a step up in basis – securities held in a taxable account receive a stepped-up cost basis upon death. There is no step up in basis for tax-sheltered accounts.

Sometimes there are advantages to holding bonds in a taxable account:

  • Provide a secure cash flow - If you are living off of your portfolio, bonds and money market funds may be held in your taxable account to produce a more secure income to meet your cash flow needs.
  • Certain bonds receive preferential tax treatment - For instance, U.S. Treasury bonds are not subject to state and local taxes, and many municipal bonds may be exempt from both federal and state income taxes.

You can be sure that we are considering all of these factors when we build and manage your portfolio. Minimizing the taxes on your investments is just one of the important benefits of working with Bay Point Wealth.

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Topics: Investment News, Tax News