Markets & Strategies

Savvy Strategies That May Reduce Taxes and Provide Additional Income

Your investment strategy can have a significant impact on your taxes — and help steer you toward your financial goals.

by Sarah Tuff Dunn - March 06, 2017

If you found that you owe more in taxes this year due to some investment decisions, taking a different approach toward tax planning — one that encompasses savvy investment strategies and focuses on your long-term financial goals — may help you out this time next year.

“You want to prioritize and think about what your investment goals are,” says Tracie McMillion, Head of Global Asset Allocation for Wells Fargo Investment Institute. “What do you need from your portfolio? Once you’ve established that, you can structure your portfolio for the potential to provide the income you need but also reduce your taxes. Or, if growth is your objective, you can structure your portfolio to grow in a tax-efficient way.”

Here, McMillion outlines some key steps for investing that include considerations for tax planning.

Reviewing tax rates

From stocks and taxable bonds to commodities and real estate investment trusts (REITs), your first step is understanding that different investments are taxed at different rates. Government bonds, for example, have the “ordinary income” tax rate, as do short-term capital gains, but long-term gains have a more favorable tax rate. REITs have an ordinary income tax rate on dividends but a favorable tax rate on long-term capital gains.

“Investments such as REITs that pay out large distributions might fare better in a tax-advantaged account,” says McMillion. She says the selling of stocks is typically what results in capital gains, but as long as the holdings are of the long-term variety, they work well in regular investment accounts because the tax on long-term capital gains are typically lower than the tax you pay on normal income.

A traditional IRA or 401(k) account, meanwhile, might be the smart choice for holding your taxable bonds. “Roth IRAs are also tax-advantaged, but in a different way. Rather than your assets being tax-deferred, you pay the taxes on the front end and then your assets grow and can be withdrawn tax-free, provided assets are held for at least five years and you’re at least 59 1/2 years old. These accounts may be a good place for taxable bonds or growth assets such as equities,” says McMillion.

Diversifying and continuing to rebalance portfolios are recommended investment strategies, but in doing so, there are several things investors should keep in mind to navigate the complicated tax rules of investment earnings.

“The most important thing to consider is that your financial goals are driving your investment decisions.”

— Tracie McMillion, Head of Global Asset Allocation, Wells Fargo Investment Institute

Buying, selling, and gifting

Timing is an important factor here because there are different tax rates that apply to different holding periods. “If you hold an asset for a year or more, then it becomes a long-term capital gain, which is currently taxed at 20%,” says McMillion. “However, short-term capital gains — those gains that you realize within a year’s time — can be taxed at a regular income rate, which right now tops out at 39.6% for federal taxes.”

So if you need to sell investments, it’s smartest to sell those that you’ve held for a longer period of time to take advantage of the lower capital gains rate. “The other thing to consider when you’re selling an asset is that you cannot turn around and purchase essentially the same asset,” McMillion adds. “That’s called the wash rule,” says McMillion, “and you can avoid that by waiting 30 days from the time of your sale” to buy the same or a very similar asset.”

Another strategy which may help reduce your tax bill is to give appreciated stock to charity in order to avoid capital-gains tax, achieving philanthropic goals while generating tax deductions.

The big picture

In the end, your long-term financial goals should inform your decision-making process — and it’s something you should consider long before the annual tax deadline.

“The most important thing to consider is that your financial goals are driving your investment decisions,” says McMillion. “Taxes are a serious consideration, but they should always be the next question, not your first priority. Your first priority is to reach your goals, and your second is to do that in a tax-efficient way. And the two really can work together.”

Sarah Tuff Dunn is a freelance writer in Vermont and a frequent contributor to Lifescapes. Her work has also appeared in The New York Times.

Additional Resources

REITs can play an important role in a savvy, tax-efficient investment strategy. Learn how real estate can help you diversify your portfolio.

All investing involves risks including the possible loss of principal. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities.

Asset allocation, rebalancing, and diversification cannot eliminate the risk of fluctuating prices and uncertain returns nor can they guarantee profit or protect against loss in declining markets.

There are special risks associated with an investment in real estate, including the possible illiquidity of the underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Wells Fargo Investment Institute, Inc. is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company. Wells Fargo Investment Institute, Inc., (“WFII”) and Wells Fargo Advisors are not legal or tax advisors. Speak to your tax advisor before investing for tax purposes.