Investors who do not manage investments in a tax sensitive manner unnecessarily give up between 1 and 2 % of their annual returns to taxes, according to Morningstar. Here are 9 ways to minimize taxes on your investments and kick your retirement savings into high gear.
1. Chose Bonds over Stocks for Tax Sheltered Accounts. You can save a significant amount by putting as much of your taxable bond investments as possible in the tax sheltered accounts (IRA’s and 401K’s). Income from bond funds is taxed at your ordinary rate of income which is almost always higher than the 15% federal capital gains tax rate that gains on stocks. (Keep in mind that tax free municipal bond funds would be an exception here as they are not taxable bond investments)
2. Use Specific identification of shares. If you are following a long term investment plan you are likely to continue to add money to your investments over time. When you go to sell part of the investment, unless otherwise specified, the shares you bought first will be the first ones sold. This is called the first in first out method, or FIFO. The Specific Identification of Shares Method allows you to choose the positions which you want to sell out of first. This can be a large advantage which allows you to significantly reduce, or even eliminate large tax bills. You can learn more about this here.
3. Tax Harvest While Avoiding the Wash Sale Rule. If you have a capital loss on one of the investments in your portfolio this can be used to offset a capital gain in another part of your portfolio, but only if the loss is realized by selling your shares. Unfortunately the IRS has something called the wash sale rule, which does not allow you to realize a capital loss unless you wait at least 31 days to buy the security you sold back.
What you can do however is sell one bond fund and then by back another fund which has similar characteristics. For example, if you had a capital loss in the Vanguard Total Bond Market Index Fund you could sell it and then use the proceeds to buy the Barclays Aggregate Bond Fund ETF (AGG). Both are passively managed funds that track the almost identical indexes.
4. Donate Investments with Large Capital Gains to Charity. When you donate investments with capital gains to charity you not only get the tax benefit for the full market value of the charitable contribution, but you also avoid paying capital gains tax on the shares you have donated.
5. Use your loss carry-forward. If your capital losses on investments are greater than your capital gains for the year, then you can deduct up to $3,000 of the capital loss to reduce your taxable ordinary income for that year. If you still have a capital loss after that, you can deduct up to $3,000 a year against ordinary income going forward as well as an unlimited amount of capital gains.
6. Do not invest in a bond fund right before it makes a capital gains distribution. Capital Gains from bond funds are normally distributed to investors at the end of the year. Even if you buy the fund a few days before the distribution is made however, you will be taxed on the full amount of the distribution as if you have held the fund for the whole year.
7. Look for funds with low turnover. If you go to Morningstar and search for the fund you are considering investing in they will tell you what the annual turnover of the fund is. From a tax standpoint the lower the turnover number is, the lower the capital gains distributions and therefore the tax bill is likely to be.
8. Choose Passively Managed Funds over Actively Managed Funds. Passively managed or “Index” funds are likely to have much lower turnover than actively managed funds. They only change their holdings when a change in the index is made.
9. Buy Municipal Bonds or Municipal Bond Funds. Money invested in municipal bonds can provide shelter from Federal ,and in many cases, state income taxes. While the before tax yields may be lower on a municipal bond funds than other types of high quality bond funds, the after tax yields may be higher. This is especially true for investors in the higher tax brackets. For more information on this visit the municipal bond section of Learn Bonds.
Have a question or other idea that is not included on this list? Please let us know in the comments section below.
Want to learn more about investing in bond mutual funds and ETFs? Visit the Bond Funds section of learnbonds.