Cailin Fraser
Designing a tax-efficient investment strategy might feel like a game of financial chess. There are a lot of moves potentially available to you. Choosing the right one requires you to look at the broader picture and think through the implications of each one. Weighing risk vs. profit potential might be the first things you consider, but it’s also imperative to look at the tax angle.
Tax-efficient investment means anticipating tax implications of all your investments and using that information to create strategies that maximize tax benefits and minimize burdens. Put another way? Tax-efficient investing is about growing your investments in ways that are aligned with your broader financial goals—without losing more to taxes than you need to.
WHAT ARE SOME TAX-EFFICIENT INVESTMENT STRATEGIES?
A tax-efficient investment strategy must be tailored to each individual investor’s goals and preferences around things like wealth accumulation and risk management. Factors such as new tax laws and shifts in the market may also force investors to revisit and rework their plans periodically. Tax efficiency should be part of the conversation any time you speak to your financial planning advisors about your portfolio. Use their guidance to help you make informed decisions about how you allocate your investment dollars.
Some potentially tax-efficient investment strategies you might consider include:
1. Maximizing contributions to tax-advantaged retirement accounts.
No matter where you are in your career, funding your 401(k), IRA and/or Roth IRA are probably going to be a top priority in your investment strategy. Spreading your contributions across accounts that have different tax treatments gives you options when you reach retirement and need a tax-efficient strategy for withdrawing money from different sources. As an example, maximizing your annual contributions to both a traditional IRA and Roth IRA could allow you to live off distributions from the traditional IRA for many years into retirement. Meanwhile the untouched balance in your Roth IRA would keep earning interest, and you could pull money out tax-free at any time.
That's just one possible strategy, though. Maxing out contributions to your retirement accounts each year may not be feasible or advisable depending on your overall financial situation and wealth accumulation goals. You may also want to explore additional methods for growing retirement savings, such as health savings accounts. Determining how much you can/should invest in various retirement accounts is something to discuss with your advisors.
2. Passing tax-inefficient investments to individuals, charities and heirs.
Any time you consider making a significant financial gift to a charity or individual, look at your portfolio before you give cash. There are certain ways to gift appreciated assets that minimize or even negate capital gains taxes. Donating capital assets to a qualified charity lets the organization sell them and keep the full profits. The charity isn't taxed on the capital gain, and you may be able to lower your own tax bill using the charitable deduction.
Or, evaluate your options for gifting capital assets to individuals. As an example, if you want to give a graduation gift to a young person in your family who is graduating from high school, it may be more tax-efficient to give them $1,000 in appreciated stock than $1,000 cash. Assuming they’re in the lowest tax bracket, they may be able to sell the asset right away without paying capital gains taxes—or, they can keep the gift and begin learning about managing a portfolio.
Tax efficiency should also be considered as part of estate planning for your investments. Putting the appropriate estate plans in place now could allow your loved ones to inherit your investments with minimal tax burden on them, and on your estate.
3. Loss harvesting.
Investments don’t always work out. Selling a capital asset at a loss may allow you to offset capital gains taxes you owe for that year. Then, you may elect to reinvest the profits of the sale into a similar asset. This way you maintain the balance of your portfolio, but now, that money is invested somewhere that you and your advisor believe is poised for growth.
4. Using investment real estate to reap tax benefits.
While it’s not for everyone, owning investment property can be a tax-advantaged way to grow wealth. There are many potential tax benefits associated with owning investment real estate, including a long list of allowable deductions that could lower your tax bill each year. For real estate investors who are ambitious about long-term growth, 1031 exchanges (or like-kind exchanges) can yield major tax savings. Thanks to this element of the tax code, you can sell one piece of investment property, use the money to buy a similar investment property and defer any capital gains tax on the sale of the first property.
A 1031 exchange is only allowed under certain conditions, but here’s a broad example of how it might look in practice: You buy a $500,000 office building, rent it out for a few years and sell it for $700,000. You can then use that money to buy an even more lucrative office building, without paying tax on the $200,000 gain. Theoretically, you can continue this pattern of selling one building and reinvesting in a more valuable one indefinitely. Capital gains tax would only be owed when you sell an investment property and don’t replace it with a similar one.
YOU DON’T HAVE TO KNOW HOW TO DESIGN A TAX-EFFICIENT INVESTMENT STRATEGY.
Sachetta, LLC’s financial advisors are here to help you understand and evaluate all your options so you can make informed investment decisions you feel good about, even at tax time. Let’s talk about your overall goals around money and investing, and go from there to identify tax-efficient investment strategies that are aligned with those specific goals. Contact us today!
Cailin Fraser, received her Bachelor's Degree from Merrimack College. Since graduating college, she has worked in public accounting with a focus on high net worth individuals. Her favorite part about working as an Accountant is tax planning and being able to advise clients. Since joining Sachetta, Cailin has mainly worked on tax projections and will continue wit tax compliance.