They Call Me the Tax Man!

Don’t you love a great music lead-in, well I do.? In any event, today’s message is a cautionary tale about investing and tax management.? You see there are certain ways to maximize your returns on an after-tax basis that are worth educating in.? It is a topic we feel strongly about in our models and planning techniques, because let’s face it, it is what you keep not what you make that matters at the end of the day.?

So, let’s take a few moments to talk about the different ways one can manage a portfolio to optimize for taxes.? Quick disclaimer, we utilize most if not all of these regularly for our clients.

Tax location!

Probably the easiest way to maximize your investments for tax management is by using a simple tax location.? What tax location means is putting the appropriate investments in the appropriate vehicles to optimize after-tax returns.? How about we look at a few examples of how to optimize your returns for taxes?

Roth IRA– For starters, Roth IRAs are fantastic savings vehicles.? Your dollars go in after-tax and thus grow TAX-FREE until your withdrawal funds in the future.? By in large, the rule of thumb we try to use at Diversified, LLC is to concentrate your most aggressive or growth-oriented investments into your Roth IRA .?

The logic here is simple.? If there is one area, you want the most growth long term it should be in a tax-free growth environment.? By doing so you can effectively pay the least amount of taxes possible as a household.? I’m not suggesting all of us will turn into Peter Thiel, co-founder of PayPal, who ingeniously put a bunch of his company stock before it turned into “PayPal” into his Roth IRA.? Today it is valued at roughly $5 billion, that is all tax-free!

IRA/401(k)/Qualified Plans– These accounts all have one thing in common, your dollars go in pre-tax and are taxed upon withdrawal.? The other unique tax advantage these accounts have is there is no tax until you take it out.? Thus, if you have dividends, or sell things at a gain you don’t have to worry about tax implications.

I tell you this so that you can follow the logic that these accounts are by far the best to concentrate your bond holdings in.? You see bonds are extremely tax inefficient, minus municipal bonds.? By their construction, they kick off dividends each year.? They really aren’t meant to be highly appreciable assets, but rather income vehicles.? As such, they are terribly tax-inefficient as these payments should be taxed at ordinary income tax rates, not even capital gains rates.? That being the case, we are a huge proponent of trying to cluster your bond holdings in your qualified plans.? This way when they pay their regular dividend payments you won’t be stuck with tax liability for doing so.

Non-Retirement or Brokerage Accounts–

The last type of account worth mentioning for tax location is your liquid brokerage account.? These accounts are the most susceptible to taxes , thus we must take the most care in our asset location here.? In general, if we are looking simply through the tax lens this is a great spot to hold stocks, and ideally not many high dividend stocks.? By doing so, we can defer most of the tax burden into the future when we need to sell these assets to live.? At that future date, you will ideally be in a lower tax bracket, plus only be responsible for paying a more favorable long-term capital gains rate on these funds.

In general, stocks are more tax-efficient than bonds by their makeup.? Certainly, if you fancy yourself a day trader you can throw this strategy right out the window.? That said, I find most people are long-term investors and by doing such are in a great position to buy and hold a good deal of their investments.?

Part 2

I toyed around with getting into more tax investment strategies today but think this is enough to chew on and consider.? More to follow in the future on tax savings techniques with your investments.?

One key thing to note in reference to one’s ability to implement the above.? In doing tax location it is most helpful if you look at your investments as one big bucket regardless of where it is held or whose name it is in (spouse or yourself).? In doing so, you can really optimize your investment portfolio for taxes.? Just know, that this may lead to wildly different experiences per account, where you can have a bond-focused IRA do 4% and your brokerage account do 20% in the same year.? This isn’t an issue, but something worth noting so you aren’t surprised later.

Hope you enjoyed this little blog on tax management.? An area we take great pride in with our planning clients and hopefully you can see the validity as so many of our clients have.

As always stay wealthy, healthy, and happy!