5 ways to make your portfolio more tax-efficient
February 24, 2017
If you think about taxes only in April, reconsider: Maintaining a tax-efficient portfolio throughout the year can help you save money on taxes—now and in the future. Read the five tips below, and face the next tax-filing deadline with more confidence than you've ever had before.
1. Save as much as you can in tax-advantaged accounts
Maximize what you save for retirement, higher education, and healthcare in tax-advantaged accounts. A number of these accounts, including traditional IRAs and employer-sponsored retirement plans, offer a double tax advantage—tax-deductible contributions and tax-deferred growth.1 Other tax-advantaged accounts, such as Roth IRAs and 529 college savings plans, provide tax-deferred growth and tax-free withdrawals for qualified distributions. 2 A health savings account offers a triple tax advantage—tax-deductible contributions, tax-deferred growth, and tax-free withdrawals for qualified healthcare expenses.
"If your investments are growing without being subject to taxation, you'll have more money in your account that can compound, or generate earnings," said Jacklin Youssef, a senior wealth manager in Vanguard Personal Advisor Services®. "Over the long term, the more you have invested, the more growth you earn."
On the flip side, taxable accounts generally don't offer special tax breaks—and you have to pay income taxes on interest, dividends, and capital gains as your investment grows.
"That doesn't mean you should avoid taxable accounts," added Youssef. "Taxable accounts can still have a place in your portfolio—you just have to locate different investment types in the right accounts."
2. Consider a conversion
Diversification applies to more than investments—it also applies to accounts. Consider adding tax diversification to your portfolio by investing in a Roth IRA.
If you don't qualify to make a Roth IRA contribution because of your income level, you can complete a Roth conversion (converting assets from a traditional IRA to a Roth IRA). The conversion will be taxed at your ordinary income rate in the year you convert, but the long-term tax diversification benefit may outweigh the immediate tax burden.
"When you're deciding if you should convert, you have to consider your tax rate now (versus later) and the immediate taxes you'll have to pay to convert. But it's also important to think about the flexibility and control the conversion can add to your future retirement and legacy plans," said Youssef.
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3. Tap into your accounts in the right order
Yes, there's a "right way" to draw down from your portfolio during retirement. Thoughtfully managing how you create an income stream in retirement can minimize your tax liability and extend the life of your savings.
For many people, the order below makes the most sense:
1. Take any RMDs. (If you don't need to spend the money right away, move it into a taxable account.)
2. Withdraw from your taxable accounts.
3. Withdraw from your tax-deferred accounts, like traditional 401(k)s and IRAs.
4. Withdraw from your tax-free accounts like Roth 401(k)s and Roth IRAs.
"The amount—and source—of income you receive when you're retired also impacts the taxability of your Social Security benefits and the Medicare premiums you pay for Parts B and D," said Youssef.
4. Harvest your losses
"Tax loss harvesting" is selling a security that has experienced a loss to offset recognized capital gains—and possibly up to $3,000 of ordinary income—which can provide tax savings for the year. Although this practice sounds intuitive, it can be complicated.
"Don't let possible complications deter you," Youssef said. "The potential savings could make it worth your while to consult a tax professional or financial advisor."
5. Be generous
Charitable giving is its own reward, but it can also offer potential tax advantages. If you donate appreciated securities you've held for more than a year, you'll qualify for a charitable tax deduction and your investment earnings (appreciation) won't be subject to capital gains tax.
IRA account owners who are subject to required minimum distributions (RMDs) also have the option to make a qualified charitable distribution (QCD), whereby they can donate their RMD (up to $100,000) directly to a qualified charity, income-tax free.
"Gifting to family members, or making direct transfers on their behalf for health and education purposes, can be another way to boost the tax efficiency of your portfolio and help you meet your wealth transfer objectives," Youssef said.
Be prepared for tax time
When nothing is certain except change, take comfort in what you can always count on: taxes. (Sarcasm intended.)
"If you keep tax efficiency in your mind throughout the year as you make investment decisions, you can efficiently manage—and maybe even reduce—your taxes now and in the future," said Youssef.
1 You may be able to deduct some or all of your traditional IRA contributions. The deductible amount could be reduced or eliminated if you or your spouse is already covered by a retirement plan at work.
2 The availability of tax or other benefits may be contingent on meeting other requirements. Withdrawals from a Roth IRA are tax-free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both. Earnings on nonqualified withdrawals in a 529 college savings plan may be subject to federal income tax and a 10% federal penalty tax, as well as state and local income taxes.
- All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account.
- Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
- When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
- You may wish to consult a tax advisor about your situation. This article is not meant as a substitute for consulting a qualified tax advisor, or to provide tax or legal advice.