There is one key factor in financial planning that connects money, investments, and decisions. It has a very bad reputation and can be infuriatingly complicated, but it provides a robust framework of planning decisions that can put dollars back in your pocket.
We are, of course, talking about taxes!
Your Investments Are Leaking
For many investment managers, taxes are a bane because they create inefficiencies within the investment portfolio. When calculating investment risk and investment return figures, taxes are largely ignored by advisors due to the wide range of their client’s unique tax situations. For those professionals most concerned with the investment portfolio itself, they may find that the overall financial improvement for their client isn’t what the portfolio growth may indicate.
Patch the Holes in Your Portfolio
There are some simple strategies to employ to help stop the leaking, which focuses on getting a higher return net of taxes from your portfolio.
If you are in a high tax bracket, getting municipal bonds instead of corporate bonds could make a big difference. On paper, municipal bonds pay less, but since they are not affected by federal taxes, they can net you a higher rate of after-tax return.
Another potential strategy could be choosing where you hold certain assets—also known as asset location. Concentrating more bonds or income-producing investments within an IRA could potentially end up netting you more over time. This is because this strategy enables you to hold a greater amount of stocks in an after-tax portfolio and experiencing the benefits from the special taxation on the capital gains and dividends of stocks.
Collect Tax Losses
Some level of taxation or “leakage” will occur, no matter how well your portfolio and financial plan are designed. However, there are some strategies that you can take advantage of every single year.
One example of such is tax loss harvesting, which is selling an investment at a loss, and then immediately buying a similar investment to remain in the market. Investors can use these tax losses to offset capital gains in other parts of their portfolio—thereby reducing their tax bill.
While this strategy may produce only a small benefit each year, we know that enough drops into a bucket over time can fill the bucket back up.
The Power of Charitable Donations
Sometimes you will end up with an investment that is highly concentrated, has a lot of gains, and would create a lot of taxation for you if it was sold. Many people hold onto these positions not knowing their options. Depending on your situation, it can be very beneficial to cherry-pick these investments and donate them.
A charity won’t pay taxes to the government, so giving away an investment, avoiding the tax, and getting a tax deduction all while helping the less fortunate can be a very beneficial strategy.