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 Rather than your assets being tax-deferred, you pay the taxes on the front end and then your assets grow and can be withdrawn tax-free, provided assets are held for at least five years and you’re at least 59 1/2 years old.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.