Tax Day has come and gone, but the memories linger on, especially the annual reminder that taxes can and do take away from your investment returns. I like to remind people (including myself!) that taxes can be thought of as one of those "good problems" to have. At least it means you're earning the income to begin with, right? And you do still get to keep the significant majority of it as your own.
That said, there's no reason you have to pay more than your legal obligation. Here are three ways you can exercise some control over the current and future tax liabilities you incur as an investor.
1)Set up tax-favored accounts – The government offers a number of ways to tax-shelter portions of your income. Through your employer, you likely have retirement plan choices such as Traditional or Roth 401(k)s or 403(b)s, SIMPLE IRAs, or similar vehicles. As an individual investor, you've also got Traditional or Roth IRAs, 529 plans (for college funding) and other opportunities. The more the merrier – take advantage of them all! Especially if your employer is matching your retirement plan contributions, that's like receiving a free "raise" from your boss. And, by the way, the younger you are, the more tax-sheltering power a retirement account offers you over time.
2)Be tax-wise with your accounts (all of them) – If you think about it, the less tax-efficient an investment is (i.e., the more taxes it tends to generate) the more you'll benefit by it being located in one of your tax-sheltered accounts, where the tax-inefficiency can magically disappear. For example, taxable bond returns are taxed at (typically higher) ordinary income rates, while stock returns are taxed at (typically lower) capital gains rates. That often translates to directing your bond funds into tax-sheltered accounts, and your stock funds into regular, taxable accounts. Consider that as you decide where to locate your holdings.
3)Take advantage of tax-loss harvesting – If you're going to have to endure a bear market now and then, you may as well get some tax savings out of it if you're able. Tax-loss harvesting can generate future savings without significantly impacting your long-range returns. It typically works by: (1) selling depreciated holdings during market downturns; (2) immediately purchase similar, but not identical, holdings so you remain invested and don't run afoul of the IRS's 30 day "wash sale rule;". This way you remain true to your long-term investment plan. (This is a significant simplification of the process, with a number of caveats we won't go into here, but you get the general idea.)
Which particular accounts and actions are right for you? It's worth noting that both tax-wise account management as well as tax-loss harvesting can generate significant tax savings during the course of your investment career … but when the time comes to withdraw the funds from your retirement accounts, these same activities may contribute to paying higher taxes at that time. Those pre-tax contributions, as well as the magically erased capital gains, both get taxed as ordinary income upon withdrawal. Roth IRAs are an exception, in that your contributions are after-tax, so withdrawals are tax-free.
I know, that's a lot to take in. Perhaps the main take-away is to realize how much value your CPA and a tax-savvy investment advisor can add by helping you steer a best-case course through the potentially conflicting opportunities and options. It's a win-win for you when your tax planner and your investment manager build a collaborative strategy to give you the financial growth you need, while minimizing those "good problem" taxes along the way!