How can an investor minimize taxes and maximize returns? I'll begin by flagging a few common mistakes, and then offer a few suggestions.
Costly Tax Errors and How to Correct Them
Error #1: Putting REITs, Bonds, and other yield-generating investments in a regular brokerage account or taxable portfolio. The cost of doing so is clear: you are taxed on the yield at regular intervals, normally upon receipt (assuming you're a cash-basis taxpayer). Investing these same assets into a tax advantaged account such as an IRA can offer an investor a double tax-benefit: (1) he could possibly deduct all or part of what he contributes to the IRA and (2) the money in the IRA is not taxed until pulled out of the IRA. Of course, there are other considerations to keep in mind. Investing in an IRA offers tax advantages, at the expense of liquidity (i.e. the funds are effectively trapped in the IRA until the investor is 59 1/2).
Suggestion: After weighing the non-tax considerations of doing so, investors might consider using a tax-advantaged account such as an IRA for yield-generating assets. If an investor wants to allocate more money to fixed-income assets than the contribution limit allows, then he might consider letting his fixed-income allotment spill over into municipal bonds. Municipal bonds generate interest that is free from federal income tax. Bonds issued by the investor's home city yield interest that is free from city, state, and federal income tax. Many brokerages offer such funds (and several ETFs exist as well). Before investing in them, however, compare the after-tax returns of the municipal bonds and comparable corporate bonds to ensure that the bonds are worth the investment.
Error #2: Owning municipal bonds in a tax advantaged account, such as an IRA or 401(k). The primary tax benefit of municipal bonds stems from their tax-free interest. Notice that the interest rate of municipal bonds are lower as a result of this tax-benefit; comparing the interest rates of municipal bonds and comparable corporate bonds reveals this disparity. By investing in municipal bonds in a tax-advantaged account, investors needlessly suffer the lower interest rate of municipal bonds. The investor could hold the higher-interest rate bearing corporate bonds in the tax advantaged account, without being taxed on that interest either (until the asset is sold and pulled out of the account).
Suggestion: All else equal, an investor should try to avoid investing in municipal bonds in tax-advantaged accounts. While municipal bonds may have a place in an investor's taxable, brokerage account, an investor is better off holding other fixed-income assets--due to their corresponding higher interest--in a tax advantaged account.
Error #3: Failing to harvest tax losses. Most investors realize that short or long-term capital losses can offset short or long-term capital gains. Use this tax benefit effectively: when selling an asset at a gain, consider selling another asset at a loss, if the asset was held for a comparable time period. More sophisticated ways of harvesting tax losses also exist. Consider this example. Suppose it comes time for an investor to rebalance his portfolio. His underperforming asset is IJR. His overperforming asset is SPY. A tax strategy that harvests his tax losses, without overly altering his portfolio allocation, is as follows. He sells a portion of SPY, which generates capital gains. To offset those gains, he sells IJR. This results in no capital gains paid. But, the investor needs to make up for the IJR sold, because he still wants exposure to small cap stocks. So, he buys enough of IWM to compensate for the IJR sold and to bring his portfolio back into balance. Notice that the IRS targets "wash sales," which includes buying "substantially identical" securities within a 30 day window (26 USC § 1091). But upon examination, this doesn't look like a wash sale. He is buying two different types of securities that track two different indexes. Of course, he should consult a tax attorney or accountant for a definite answer and to ensure compliance with the Internal Revenue Code. But assuming this suffices, his portfolio isn't harmed much as a result. Both IJR and IWM are comprised of small cap stocks and give him similar exposure.
Suggestion: Think about harvesting tax losses, when it comes time to sell an asset at a large gain.
Error #4: Rebalancing portfolios by selling and buying. When it comes time to rebalance, a common strategy is to sell overperforming assets and buy underperforming assets. But this takes two bites into an investor's capital: (1) he pays commissions on both the sale and the ensuing purchase, and (2) he pays capital gains on the sale of the overperforming asset. A much more tax-efficient strategy is to only buy the underperforming asset to bring the allocation back into balance. Notice that this avoids any capital gains taxes and it results in only one level of commissions (on the purchase).
Suggestion: For those who have the extra cash to do so, rebalancing by buying more of an underperforming asset is a wise tax move. For those who do not have enough funds to do so, consider harvesting tax losses to minimize the tax burden of rebalancing.
Error #5: Ignoring commission-free funds. This is not a tax strategy per se, but it bears mentioning. Dollar-cost averaging is a useful concept, but the commissions involved can eat away at an investor's capital. If an investor wants to buy a set amount of SPY each month, for example, he will end up paying a hefty sum in commissions each year. A strategy of investing set amounts at regular intervals--such as monthly--works best with commission-free funds. Yet nonetheless, too many investors ignore the cumulative effect of commissions on their overall returns.
Suggestion: Think about constructing a portfolio out of commission-free index funds, and then investing a portion into those funds on a regular basis.
These are merely five ways that investors undercut their returns by ignoring tax implications. Hopefully, these suggestions will help others craft a more tax-efficient portfolio. Please keep in mind that there other considerations--such as liquidity, the effects of short versus long-term capital gains/losses, non-tax considerations, and the legal elements of a wash sale--which this article omits, but which should also be taken into account before making any investment decisions. Consult a financial advisor, attorney, and/or perform your own research, before making relevant investment decisions.
Additional disclosure: This communication is for informational purposes only. As of this writing, the author is not an attorney or a certified financial planner. Any U.S. Federal Tax advice contained in this communication is not intended or written to be used, and cannot be used, for avoiding penalties under the internal revenue code or promoting, marketing or recommending to another party any tax-related matters addressed herein. This post is not intended as a solicitation or endorsement for legal services, and all data and all information is not warranted as to completeness and are subject to change without notice and without the knowledge of the author.