“What is the difference between a taxidermist and a tax collector? The taxidermist takes only your skin.” – Mark Twain
The old adage, “It’s not what you make, but what you keep that matters,” is very real. As we have all heard, the only two things are certain in this world are death and taxes. Uncle Sam always gets paid. So, any way that you can legally pay less in taxes is an instant boost to your income and/or net-worth.
What are some ways to optimize your After-Tax Returns?
Optimize Use of Tax-Advantaged Accounts
Taxes are a major drag on returns, it’s always important to consider the account in which securities are held so as to minimize current and future tax impacts. Account selection is just one of many tax-related factors that must be considered early in an individual’s financial journey.
Taxable Accounts provide greater liquidity and withdrawal flexibility, but don’t carry any tax advantages. Dividends, interest, or capital gains resulting from an asset sale get taxed each time one occurs. Taxable accounts, such as brokerage accounts, are best suited for tax efficient investments, such as passively managed funds, zero-coupon bonds, or no-dividend stocks. However, there is one way to effect your tax rate, by holding investments for longer than 1-year. If you hold an asset longer than a year before selling, you are then taxed at the current Long-Term Capital Gains Rate which is currently capped at 20% which is much lower than the Ordinary Income Tax Rate of 37%. So, if you need to sell, all else being equal, selling long-term assets is most tax advantaged
Tax-Deferred Accounts are funded with pre-tax dollars. Though any activity in the account — dividends, interest, capital gains — is exempt from taxes, each distribution is subject to taxation. But, contributions to tax-deferred accounts can be deducted from tax returns, thereby lowering the amount of annual taxable income. This makes tax-deferred accounts like a traditional 401(k) or IRA best for both high-income earners and tax inefficient investments. Another advantage of having assets in these accounts are that you can rebalance your portfolio as much as you’d like without triggering any taxable events.
Tax-Free Accounts offer a benefit exactly as the name suggests: they are tax-free. Not only is activity within the account tax-exempt, but distributions occur sans tax as well. Because tax-free accounts like a Roth 401(k) and IRA are subject to income limits, it’s best to contribute as much as possible during periods of lower income, as well as store investments that can return the greatest amount. A Roth 401, Roth IRA, and 529 plans can be a very powerful tool for investors with extremely long-time horizons. See another article I wrote here about tax-free gains by turning $10k into $1 million using a Roth account.
While is extremely difficult to avoid taxes entirely, optimizing the use of the different accounts based on your unique situation can dramatically impact how much money you actually end up with.
Use Financial Metric Tools to Analyze After-Tax Returns
In addition to a sale event (taxable account) or account withdrawal (tax-deferred account), investors can face additional tax liabilities due to mutual fund or ETF managers’ decision-making. Some useful metrics for evaluating funds potential tax liabilities include:
The Bottom Line
Taxes are rarely clear-cut; as income levels, portfolio values, investment goals, risk tolerances, and life itself change over time—and each factor plays into tax considerations.
Having said that, it is possible to plan with various “what-if scenarios” to help maximize returns under various assumptions to limit tax liabilities owed to Uncle Sam. Using these best practices for tax-efficiency with a little up-front planning can lay a roadmap for success and maximize the rewards of a well-built financial plan.
-Paul R. Rossi, CFA