Establishing a tax management strategy for your investments can help you keep more of your 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.
Use Tax-Aware Asset Location
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 taxable assets which may generate income, such as dividend-paying stocks and corporate fixed income, to tax-deferred and tax-exempt accounts such as Individual Retirement Accounts, you can help minimize your exposure to current taxes. In contrast, consider purchasing nontaxable assets, such as municipal bonds, in taxable accounts. Your Financial Advisor can assist you and your tax advisor in structuring a tax-aware asset location strategy across your accounts.
Consider Tax-Favorable Investment Solutions
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 qualified educational expenses, such as college tuition.
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.
Finally, if you’re charitably inclined, consider giving to a donor-advised fund (DAF). When you donate to a DAF, you become eligible for a federal income tax deduction for your contribution, while also retaining advisory privileges to recommend which charities should receive the donated amount currently or in later tax years. This amount may grow through investments over time.
Employ Tax-Loss Harvesting
Current U.S. federal 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 federal income tax liability. Capital gains are generally the profits you realize when you sell an investment (e.g. stock, personal real estate, art, etc.) 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 in future years.
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 about your options.
Max Out Retirement Plans
Consider maxing out contributions to your account under your employer’s retirement plan, such as a 401(k) plan, since contributions can be made on a pretax basis. Contributing to a traditional IRA can also lower your taxable income for the current year, since contributions may be tax-deductible.1 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.
For the 2022 tax year, you can contribute up to $20,500 ($22,500 in 2023) to your 401(k) account. If you’re saving in a traditional IRA, you have until the tax deadline (April 18, 2023 for the 2022 tax year) to contribute up to $6,000 in 2022 or $6,500 in 2023. In 2022, those age 50 or older can boost those contributions by $6,500 in their 401(k) ($7,500 in 2023) or $1,000 in a traditional IRA ($1,000 in 2023).
Additionally, depending on the plan, you may be able to take a loan from your 401(k) account of up to the lesser of (i) 50% of your account balance or (ii) $50,000 less the highest outstanding loan balance in the preceding 12 months. The loan must generally be paid back with interest within 5 years. If you are considering taking an early withdrawal or loan from your 401(k), discuss the appropriate strategy with your tax advisor.
Engage in Legacy Planning and Gifting
For 2023 the federal estate tax exemption increased to $12.92 million per individual and $25.84 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 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 before year-end. In 2023, those limits rise to $17,000 for individuals and $34,000 for married couples electing to split gifts. It is noteworthy that gifts in the form of tuition payments made directly to an educational organization, as well as medical expense payments made directly to the provider, are not taxable gifts and do not count against the annual exclusion amount for gifts or reduce your federal lifetime gift tax exemption.
Help Minimize Your Overall Tax Bill
Morgan Stanley Financial Advisors offer tax-smart techniques and strategies to help you reduce the impact of taxes, all year round, as part of our Total Tax 365 approach. Talk to your Morgan Stanley Financial Advisor to learn more.
In addition, if you have complex tax planning needs, your Morgan Stanley Financial Advisor can connect you to experienced tax professionals at leading U.S.-based providers across the country to help ensure your tax strategy is optimized.