A tax-savvy investor knows how to employ strategies to reduce taxes. Helpful methods are 1) asset location, 2) tax-managed mutual funds, 3) index exchange-traded funds and 4) tax loss harvesting.
Finally, higher income earners (individuals and jointly filing couples who exceed $200,000 and $250,000 of modified adjusted gross income, respectively) may consider some investments – such as municipal bonds and qualified dividend-paying stocks – to reduce net investment income in light of the 3.8 percent surtax on investment income for wealthier folks that began last year.
Asset location. Think of your investment portfolio as a garden. Certain plants do well in full sunlight, but others benefit from shade. Plants designed to flourish in the shade can wilt and die in full sunlight. Similarly, some investments do exceptionally well in tax-deferred accounts but others are better suited to taxable accounts. Ideal investments for tax-deferred accounts include real estate investment trusts (REITs), commodities (buying futures contracts can bring you taxable gains), most bonds and bond funds and high dividend-paying stocks.
Conversely, self-described tax-efficient stock mutual funds, growth-oriented stocks and untaxed municipal bonds all fare better in taxable accounts. Your time horizon also counts – if you’re in your 50s, concentrate more bond holdings in tax-deferred accounts. However, if you’re several decades from retirement, hold relatively more stocks in your tax-deferred accounts since they should outpace bond growth for an extended period before you tap them.
Roth individual retirement accounts are ideal for holding stocks that you can allow to run for decades. You invest in a Roth IRA with after-tax dollars, and it grows tax-fee from there on out. Plus, this account has no required minimum distribution, like a regular IRA or 401(k), where you must start withdrawing from it at age 70½.