Taxes and Investing
It’s been about ten years since I started my first year in the Accounting program at The University of Missouri. I graduated with my tax certificate along with my master’s in accounting in 2012 and have worked in the same field since then. I wish I could say that dedicating my career/education to taxes over the last decade has allowed me to know everything about our tax law, but I will admit that there are many areas of tax that don’t fully understand. In my defense, they did change the laws in 2017!
That’s why I am never surprised that taxes are always among the most important financial topics for families and businesses. They are complicated! We all want to figure out how to keep as much of our income as possible. Although, I’m still waiting for the phone call from someone asking how they can pay more in taxes! Luckily, the IRS will gladly accept tips.
I’d like to cover how taxes impact investing so that all of you don’t need to go out and get a degree in taxation. I will talk about ways to reduce your tax bill, of course, but I will also discuss why it isn’t always the best strategy to let your tax bill determine your investment decisions. There is no perfect plan for everyone or a magical way to never pay taxes again. The important thing is to incorporate strategies that minimize your tax burden throughout your life (and death) and match your overall financial plan.
· Utilize Retirement (and Health Savings) Accounts – This is the golden rule of reducing your tax bill. Take advantage of these accounts as much as possible. Traditional accounts can give you a tax break in the current year. Roth accounts can give you tax-free distribution during retirement. HSA’s can give you both if they are used for medical expenses. All of these accounts allow your investments to grow tax free. This means that any gains, dividends, or interest paid in the account are not taxed in the year they occur. I can’t tell you exactly which accounts are right for you, but most people should be utilizing a 401(k), IRA, or HSA. You may even be able to utilize all three of these!
· 529 Plans – Saving for college? 529 plans can give you a state tax deduction in the current year and grow tax free. Gains on any withdrawals can be tax free if they are used for education.
· Capital Gains and Dividends – Capital gains receive a favorable tax rate if the investment has been held for longer than one year. This rate can even be as low as 0%. Qualified dividends also receive the favorable capital gains rate. Investments that will incur these should be kept in taxable accounts, whereas investments paying interest are better placed in retirement accounts because interest is taxed at ordinary rates.
· Mutual funds in tax-deferred accounts – Mutual Funds own a range of investments within the fund (i.e. US stocks). The funds are buying and selling these investments throughout the year which cause taxable events. Mutual Funds distribute all the gains from these events at the end of each year. The gains must be reported on the investor’s tax return. Two things that can allow you to avoid this tax. First, hold mutual funds in tax deferred accounts such as retirement accounts. Second, invest in ETF’s instead of mutual funds in your taxable accounts. I encourage you to read my previous blog post on the difference between these investments.
· Sell some gains – Everything up until this point has given you suggestions to minimize your tax bill. Now I want you to increase it. One of the biggest mistakes I have seen investors make is not selling stocks because they don’t want to pay taxes on the gains. This can lead to major problems in your portfolio. Everyone assumes that stocks will continue to go up in price over time, but it doesn’t always work that way. Stocks can always become worthless. Continuing to hold on to stocks that are rising in value can also lead to your portfolio becoming too concentrated. Just think about all those Enron employees who invested their 401(k)’s in the company stock. Their entire 401(k) became worthless. You don’t need to get rid of all your stock when it performs well, but selling some can help you reduce your risk in the event that the company has unforeseen issues.
· Tax loss harvesting – This topic can get complicated, but the main concept is to minimize your tax bill by selling the investments that have losses at the end of the year. The next step is taking that money and reinvesting in similar, but not substantially the same, investments. Let’s say you decided to sell some Apple stock that has done well and you want to diversify your portfolio. You will be required to report capital gain. Tax loss harvesting attempts to reduce your tax bill by selling investments that have a loss to offset the gain you just recognized. In addition to offsetting gains in the current year, you are also able to deduct up to $3,000 of losses from your ordinary income such as W2 wages. The ideal scenario for tax loss harvesting is to pay no capital gains and deduct $3,000 on your tax return. However, it is essential that you don’t mess up your investment mix during this process. I don’t recommend trying this strategy unless you use a brokerage account that does it automatically for you.
Let’s assume you are not someone who thinks about taxes every day. Why does all this matter? Aside from wanting to pay less tax in general, proper tax strategies can result in about a 1% difference in after-tax investment returns. I have mentioned many times before that 1% doesn’t sounds like much, but it can be the difference between retiring comfortably and having to work an extra few years. Don’t want the stress of worrying about this yourself? There are advisors who will incorporate these strategies into your financial plan. It’s one of the main reasons I started my financial planning firm. Taxes are critical to the investment decision process. I was seeing the consequences of improper tax planning when I prepared tax returns. I may not be able to recite every sentence of the tax code, but I have studied these strategies to provide the best options for my clients. You may not need the services of a financial advisor right now, but make sure to evaluate your investment strategy to take advantage of these tax strategies because everyone loves saving on taxes!
Mike Zeiter, CPA/PFS