Tax-Smart Moves to Help You Keep More of What You Earn
Dan Hunt: Hello, and welcome to another edition of Wealth Management Insights. I’m Dan Hunt, Head of Portfolio Construction & Investment Tools at Morgan Stanley Wealth Management.
For most people, investing is what you do because you want to retire with the lifestyle you’re accustomed to, put your kids through college or build a legacy. In other words, investing is a means to an end, not an end in itself. If you feel you’re not on track to meeting your goals, there are different ways to address such a situation. The most obvious of these are saving more, delaying the goal, or otherwise reducing its ambitiousness, or increasing your portfolio’s growth potential by increasing its risk. These options, however, tend not to be desirable even if they are feasible. What’s more, you may already have as much risk in your portfolio as you’re comfortable with, making further increases in risk inadvisable. What then?
One alternative that’s available to many investors is to become more tax efficient. In other words, to reduce the tax take of your investment earnings.
Taxes are a substantial drag on wealth accumulation because they hamper the powerful effects of compound growth rates. In other words, investors will never earn additional investment returns on the dollars that were paid out as taxes. So even small reductions in taxes can have a big impact on wealth accumulation over time.
There are several approaches to reduce the bite that taxes can take from investment returns.
First, consider securities and account types that are tax-exempt. Let’s take municipal bonds for example. While the yields on municipal bonds issued by US states and municipalities are generally lower than those of other issuers, all else equal, those interest payments are generally exempt from federal income taxes and, if the investor lives in the state of the issuer, from state and local taxes as well. This can often make their after-tax yields more attractive than taxable alternatives.
Second, look to structures and strategies that defer taxes to a later date. While this does not lower the absolute amount of taxes owed, it permits investors to earn compound returns unencumbered, which can make a massive difference to ultimate wealth. To defer taxes, investors can use account structures such as 401(k) plans and traditional IRAs, where investments can grow without incurring tax, which is typically assessed only when funds are withdrawn. Contributions to these accounts may also be tax deductible, which magnifies their potential impact. Taxes on taxable investments in taxable accounts can also be deferred to a certain extent, through carefully selecting security sales so as to minimize realized gains or to harvest losses, the latter of which creates near-term tax deductions.
Lastly, consider the combined effects of both tax-exemption and tax-deferral, as these securities and account types can work together to complementary effect. For example, tax-efficient asset location involves placing less tax-efficient and higher-growth investments in tax-advantaged accounts, and more tax-efficient and lower-growth investments in taxable accounts. This can significantly enhance the ability of tax-advantaged accounts to deliver tax benefits. Furthermore, for retirees who need to make withdrawals to cover spending needs, tax-efficient withdrawal strategies can help when it comes to electing the account types, securities and even tax lots that are used in a way that minimizes the tax hit. In that sense, working with your Morgan Stanley Financial Advisor to build a tax-efficient withdrawal strategy to meet your needs can help you stretch your retirement nest-egg to the fullest extent possible.
Tax-efficient strategies are not a guarantee of superior performance, but our research indicates that they hold out significant potential for improving the chances of meeting your financial goals. More importantly, they can accomplish this without exposing investors to additional investment risk.
While I’ve outlined a few examples of tax-efficient strategies, individual circumstances can make a big difference in what works best, so it’s important to review with a professional before making a determination. For a copy of an in-depth special report about these strategies, called “Tax Efficiency: Getting to What You Need By Keeping More of What You Earn,” or to learn how these strategies might fit into your portfolio and financial journey, please reach out to your Morgan Stanley Financial Advisor. Thank you for listening.
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Asset Class Risk Considerations
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Tax-loss harvesting. IRS rules stipulate that if a security is sold by an investor at a tax loss, the tax loss will not be currently usable if the investor has acquired (or has entered into a contract or option on) the same or substantially identical securities 30 days before or after the sale that generated the loss. This so-called “wash sale” rule is applied with respect to all of the investor’s transactions across all accounts
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