William Sweet, CFP®, is an Investment Advisor at Ritholtz Wealth Management. Bill has spent much of his career minimizing the impact of income taxes on investment returns. He served on active duty in the US Army as an Armor Officer for six years and was awarded the Bronze Star for valorous action in combat in 2003 during Operation Iraqi Freedom. Bill holds a degree in Computer & Systems Engineering from Rensselaer Polytechnic Institute (RPI). You can read his prior work here.
This is the third in our series on investors and taxes.
Last time, we covered the dumb things that people do to increase their refund and decrease the income tax they pay, which are mostly in defiance of logic or the law.
Today, we’ll cover a basic list of things that smart people do to achieve the same goal, ultimately leading to less taxes paid and a higher tax refund.
Hold the Right Type of Investments in the Right Type of Account
If you have investments in stocks, bonds, ETFs, or mutual funds, you may hold them in a taxable brokerage account. The other option is a tax-qualified account such as an IRA or 401k plan, which either shields or defers taxation until the account is distributed.
Certain types of assets are more or less tax friendly than others. Interest income and foreign dividends, for example, are pretty inefficient if produced in a taxable account. Distributions from these sources are taxed at your ordinary income rate, which can be as high as 39.6% for Federal taxes, and 12.7% for State & City taxes in New York. Plus, you don’t have any control over when these distributions occur – the investment company does.
Qualified dividends (generally from US-based companies) and long-term capital gains receive favorable tax treatment. These are taxed at 15%, 20%, or 23.9% (depending on your tax bracket), which is a serious reduction in tax. New York does not have a favorable tax treatment for these assets, though.
Even if favored, capital gains distributions from actively-managed, high-turnover mutual funds can wreak havoc on a tax return, since the taxpayer generally has no control over when these occur. 2015 was a good example of a nightmare year for tax distributions – a year when markets had generally declined, yet many funds distributed capital gains to investors, forcing them to pay tax today for an asset that had declined in value!
For long-term growth, the best type of investment to hold in a taxable account is one that doesn’t distribute income at all. The tax from an income-producing asset acts as a drag on the total return of an investment. While dumb taxpayers focus on gross (before fee, before tax) returns, smart taxpayers pay closer attention to after-fee, after-tax returns. We don’t pay our bills on pre-tax returns after all.
Max Out Those Tax Qualified Accounts
If you can afford to do it, it’s definitely a great idea for you to max out your annual 401k, 403b, 457b, IRA, or SEP IRA every single year.
A taxpayer in the highest marginal tax bracket (39.6% / 8.8% / 3.9% for Federal / State / City, respectively) shields about $523 of income for each $1,000 contributed to a tax-deferred account. That’s a maximum of $9,414 of tax savings every single year ($12,290.50 for taxpayers over 50).
Would you like to sign up for a $12,290 tax reduction? Go talk to payroll and max out your 401k this year!
Sign Up For a Health Savings Account
A HSA is the ideal way to maximize your tax efficiency if you spend any significant funds on health-related expenses throughout the year. You need some help from your employer with this one – the requirements are a little tricky.
If you do qualify, you can contribute up to $6,650 per year to a family HSA. If you use those funds for qualified medical spending, you do not have to pay income tax on the entire amount.
For our hypothetical mega-taxpayer, that results in $3,478 of maximum tax savings.
Document, Document, Document
Keep records and receipts for EVERYTHING. I don’t know why this is so hard for people.
Just do it!
Record every single expense that may be tax-deductible and keep those records for a minimum of three years after the filing deadline. Especially cost/basis of your stock purchases. If you can’t handle having the paperwork around, invest in a scanner and keep the PDFs. It’s not difficult to do. It just requires some discipline.
There are no excuses!
In conclusion, I feel that taxpayers spend way too much time focused on the amount of their refund (the large tax shops take advantage of this) and not enough time thinking about how to structure their investments in a tax-efficient manner. Asset location matters quite a bit, because every basis point you can keep compounding your portfolio and out of Uncle Sam’s coffers, the better off you’ll be.