Hold On To Investments For More Than A Year
The Internal Revenue Service distinguishes between long- term capital gains—on investments held for more than a year—and short-term gains. If you’re a wealthy investor who held on to a stock for more than a year before selling it, the most you’ll pay is a capital gains tax of 20 percent, plus a 3.8 percent tax on investment income. If you sell the stock before the year is up, you’ll pay ordinary income tax rates, which go as high as 39.6 percent.
Put Tax-Inefficient Investments In 401(k)s And IRAs First
Some investments will put you in a higher tax bracket by their very nature. If you own an equity fund and the manager is constantly buying and selling for short-term gains, you’ll probably end up paying a high tax rate on those gains each year. Also inefficient for tax purposes are high-yield corporate bonds, real estate, and real estate investment trusts, or REITs.
But the tax disadvantages of these investments don’t matter if they’re held in 401(k)s and IRAs. So it usually makes sense to put tax-inefficient investments in tax-advantaged accounts first. When your options for 401(k)s, IRAs or 529 plans are exhausted, it’s best to put more efficient investments—like most index mutual funds and exchange-traded funds—into taxable accounts.
Meanwhile, some investments really make sense only in a taxable account. Municipal bonds, for example, pay out relatively low interest rates—it’s often barely enough to beat inflation. But that interest income is often exempt from federal tax. If you hold a muni bond fund in an 401(k) or IRA, you're not taking advantage of the investment’s main appeal.
Weigh Your Withdrawal Strategies
When an investor gets to retirement, her nest egg is often spread across three kinds of accounts: taxable accounts, tax-free accounts like Roth IRAs, and tax-deferred traditional IRAs and 401(k)s. That allows several strategies that can end up lowering tax bills, if you choose carefully when you tap the income.
Planning the right strategy may require an accountant and some math. But there are obvious moves to consider. In a year when your income is abnormally low—maybe you’re between jobs, or you just retired and you’re living off savings—it can make sense to tap a traditional IRA and convert it to a Roth IRA.
According to a new paper in the Financial Analysts Journal, the most tax-efficient strategy can make a portfolio last six years longer than an inefficient strategy would.