Establishing a tax management strategy for your investments can help you retain more of your investment returns.
Even investors who spend a lot of time thinking about how to maximize their portfolios for performance may lack a strategy when it comes to taxes on those returns.
Applying an active tax-management strategy for your investments may be one way to help reduce your overall tax burden.
Even small reductions in tax payments today can have a big impact on your wealth tomorrow. Consider putting in place some or all of the following potential solutions.
Different kinds of accounts are taxed differently. A tax-aware asset location strategy that accounts for those differences may increase your after-tax returns. For example, by allocating higher-yield assets, such as high-dividend-paying stocks, to tax-deferred and tax-exempt accounts, such as Individual Retirement Accounts, you can help minimize your exposure to current taxes. Your Financial Advisor can assist you and your tax advisor in structuring a tax-aware asset location strategy across your accounts.
Many investments allow you to save for a variety of goals while also offering tax benefits. Municipal bonds, which are typically exempt from federal (and in many cases, state and local) taxes, can be a tax-efficient investment against current and potentially higher tax rates. Beyond municipal bonds, consider tax-efficient mutual funds or separately managed accounts that aim to limit the number of taxable events within your portfolio.
If you’re saving to cover future education costs, a 529 savings plan is a tax-advantaged way to save for educational expenses, such as college tuition. As of 2018, you can also make federal income tax-free qualified 529 withdrawals of up to $10,000 per beneficiary per year to pay tuition for a K-12 school. Additionally, as of 2019, you can now take federal income tax-free 529 plan distributions for certain apprenticeship expenses and student loan repayments.1
Many states are also extending 529 plan state-tax benefits, including receiving state income-tax deductions for contributions and withdrawing funds state-tax-free, when they are used for K-12 tuition. However, the state tax treatment of 529 plans (including the state tax treatment of contributions and distributions) may be different from the federal tax treatment and may vary based on the particular 529 plan in which you participate and your state of residence.2
The 2017 tax law limited itemized deductions, making it harder for taxpayers to exceed the standard deduction. However, donating through a donor advised fund can help you aggregate your charitable contributions, allowing you to exceed the standard deduction. Because a donor advised fund is maintained and operated by a public charity, if you itemize deductions you’ll receive the full tax benefit when you contribute to the fund, up to the per-year charitable contribution limit, and you can make recommendations to distribute the funds to your favorite causes over time.
For retirement savers, diversifying your retirement portfolio with a variable annuity may provide tax-deferred growth potential, guaranteed lifetime income, increased retirement savings, equity upside potential, and a death benefit for named beneficiaries.
Current U.S. tax law permits tax-loss harvesting, a process by which you can offset capital gains with capital losses that you’ve incurred during that tax year, or carried over from a prior tax year, which could lower your tax bill. Capital gains are generally the profits you realize when you sell an investment for more than you paid for it, and capital losses are generally the losses you realize when you sell an investment for less than you paid for it. If your capital losses exceed your capital gains, the excess capital losses can be used to offset up to $3,000 of ordinary income each year. Any additional excess capital losses can be carried forward as potential tax offsets.
When engaging in tax-loss harvesting, be sure you don’t inadvertently participate in a “wash sale,” which can occur when you sell or trade stock or other securities at a loss, then buy substantially identical stock or other securities within 30 days before or after the sale date. Talk to your Financial Advisor to learn about your options.
If your tax burden is rising, consider fully funding your employer-sponsored retirement plan, such as your 401(k), since contributions can be made on a pretax basis. Contributing to a Traditional IRA can also lower your tax bill, since contributions may be tax-deductible. Because these are tax-deferred accounts, you generally won’t pay income taxes on contributions, or any earnings from your investments, until you withdraw funds.3 For 2021, you can contribute up to $19,500 to your 401(k) plan, or $6,000 into your Traditional IRA; savers 50 and over can contribute up to an additional $6,500 and $1,000, respectively.
For 2021, the federal estate tax exemption increased to $11.7 million per individual and $23.4 million for a married couple. Regardless of whether you will generate estate taxes, all investors should have an estate plan that reflects their wealth-transfer goals and objectives. Trusts can be an effective tool to reduce estate taxes, or assure a fair distribution of wealth among family members. Taxpayers with taxable, or potentially taxable, estates who would like to leave money to their family members should consider making lifetime gifts to those family members now. This can also be a tax-efficient wealth-transfer strategy because it removes any future appreciation in the gift’s value from the client’s taxable estate. Also, consider making annual exclusion gifts to individuals and charities before year-end (for 2021, these can be gifts of up to $15,000 per recipient for individual taxpayers and $30,000 for married couples electing to split gifts). Morgan Stanley’s Donor Advised Fund may be a good solution to help you achieve your charitable giving strategy.
These investment strategies can help minimize your overall tax bill. Contact your tax advisor and Financial Advisor on which strategies might be appropriate for you.