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How to Lower Your Taxes: Take a Hard Look at Your Investments

How to Lower Your Taxes: Take a Hard Look at Your Investments

| May 07, 2019
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Tax Minimization Napa Valley, California. Kelly Crane, Wealth Management.

This article is part of our Tax Management series. A core part of our mission is to help our clients pursue their targeted returns with the least risk possible, and tax planning is a critical component. When you increase your overall bottom line through tax savings, you can typically afford to reduce your investment risk.


Investors with a portfolio larger than $500,000 often pay more taxes than they have to. A common culprit, grossly overlooked by investors and advisors alike, is tax inefficiency within their investments.  

When you’re trying to accumulate wealth, tax inefficiency dilutes your ability to leverage the power of compounding. Therefore, tax planning is truly a cornerstone of effective wealth building. In this article, part one of our series, we'll unpack ways to reduce your investment taxes.  

Your investment income is the most heavily taxed part of your financial plan. If you want to minimize your tax bill, start with your investments. Not only is investment income billed at your highest tax bracket since it’s added on top of your earned income but it also increases your entire taxable base. When you’re trying to accumulate wealth, this can seriously dilute your ability to leverage the power of compounding inside your portfolio.

Let’s unpack ways to reduce your investment taxes and boost your wealth building.

An Example of Inefficient Investment Tax

An executive with an annual income greater than $200,000 could easily be taxed at some of the highest rates.  

Joe makes $250,000 per year, and he files “married, filing jointly.” For 2019 his total income-tax rate will be 33.3% (24% federal and 9.3% California). For his investment earnings that are fully taxable (not all are—more on that below), those will be taxed at these top earned-income rates for a combined 33.3%.

If his $500,000 portfolio generates a 6% annual income ($30,000), he’ll lose 33.3% of that growth ($9,990) to taxes. This will happen every year.

This, of course, is counterproductive to accumulating wealth. The solution: Joe needs to look for more tax-efficient accounts to reduce this liability.

5 Signs That You Could Reduce Your Investment Taxes 

If you fall into one of the following groups, chances are you could reduce your investment taxes: 

  1. Buy-and-Hold Investor: If you're an investor who buys and holds an investment for years and never analyzes if it's still a good investment, chances are you're sitting on a holding that doesn't match your tax picture. We see this often with employees who own employer stock and for those who inherit a portfolio that they never managed (such as a spouse or adult child). Often these two groups maintain the portfolio allocation without assessing its tax efficiency, or its risk for that matter.
  2. Your Income Changes: As your income changes, so can your income-tax rate, and since many investments are taxed at your earned-income rate, your investment taxes will likely grow with your income.      Want to Lower Your Taxes? Step One: Reduce Your Investment-Income Tax. Your investment income is the most heavily taxed part of your financial plan.
  3. You're Having a Banner Investment Year: Your taxable investment gains could bump you into a higher tax bracket. Since they are counted as income and added on top of your total income for the year, gains effectively increase your total taxable income. That means all of your income will be taxed at a higher rate.
  4. Tax Law Changes: Updates to the tax code, such as the significant tax changes in 2018, happen almost every year and can trigger changes in your tax liability. So, basically, this applies to everyone, every year.  
  5. You're Getting Ready to RetireWhen you retire, several significant tax changes occurboth immediately and in the years that follow: the loss of steady job income, the addition of social security, and required IRA minimum distributions are the big ones. To minimize investment taxes, it's critical to create a proactive tax plan around these changes to keep your overall tax rate to a minimum.    

How to Reduce Your Investment Taxes 

While it’s unlikely you’ll be able to reduce your investment tax to zero, more often than not, investors have a myriad of tax-whittling opportunities sitting in their portfolio. 

The key to reducing taxes within your investments requires understanding the following:

  • Tax management: three strategies to lower your taxes. Tax efficiency within your portfolio is a wealth building opportunity.What you want your money to do for you 
  • When you will need access to your money 
  • The risk you’re comfortable taking 
  • How each type of investment is taxed  

Here are five strategies to reduce your overall tax bill by making your investments tax efficient. 

Step 1: Match Your Investments to Your Goals

This might seem obvious, but many investors have a portfolio that is completely disconnected from their long-term plans and short-term cash needs. To create a more tax-efficient portfolio, it’s imperative to first understand 1) your short- and long-term cashflow needs and 2) your life goals (i.e., In three years I will retire and will need $7,000 per month for living expenses and $150,000 to buy a 30-foot weekender).

Documenting these goals in your financial plan will help you place your money in the right type of accounts. You wouldn’t want to place money you’ll need in three years in an illiquid or a high-risk account.  

Step 2: Diversify Your Investments Across Accounts That Are Taxed Differently

The U.S. tax code, which is added to—not simplified—most every year, taxes different sources of investment income at different rates. The rules can be quite complex, and the rate applied depends upon a number of factors, such as the type of account (i.e., tax-deferred retirement account vs. an annuity), the type of money coming to the investor (income, yield, dividend, or profit from sale), and the length of time held (i.e., short-term vs. long-term capital gains).

To strategically organize your portfolio and minimize your tax liability, you need to understand how each account is taxed and which areas of your tax return are impacted by your investments. The key is to utilize a mix of investment account types according to how they are taxed. This will give you a variety of investment income sources with varying tax implications.

Most investment accounts are either fully taxed, tax deferred, or tax free. For those that are taxed, the tax rates can greatly vary depending upon how long you’ve held it and your personal tax picture.

Let’s unpack both. Following are more details on the investment account types and then on the investment tax rates.

Types of Investment Accounts: How They Are Taxed

As we’ve mentioned, when considering how your gains are taxed, there are three basic investment account types: fully taxable, tax deferred, and tax free. 

Tax-Free Investment Accounts:Reduce Your Taxes: The Power of Tax-Efficient Investing.

Fully-Taxable Investment Accounts 

Accounts such as CDs or interest-bearing bonds are fully taxable. You'll pay ordinary income tax on the profit from these investments (your highest federal tax rate) in the year the gain was generated. 

Tax-Deferred Investment Accounts 

Accounts such as IRAs, 401ks, 403bs, annuities, and life insurance are tax-deferred. Put money into these accounts before you pay taxes, and you'll pay ordinary income taxes on your withdrawals later in the year you pull it out of the account. The benefit:  The principal grows tax-deferred.  

Tax-Free Investment Accounts 

Accounts such as Roth IRAs, Roth 401ks, and some life insurance grow tax-free. You fund these accounts with income you've already paid taxes on. The account grows, and you won't pay federal income taxes on qualified withdrawals later.  

Tax-Defferred Portfolios:     Tax Management: three strategies to lower your taxes

Investment Tax Rates 

For your investment gains that are taxed, the tax rates depend upon the type of investment and on your tax picture. The exact rate gets personal as it depends upon your overall income and filing status. For example, the long-term capital gains rate for a single filer with an income of $35,000 will be different than the tax rate for a married couple making $400,000 per year. This is why personalized tax planning is so important.   

For the big picture, it’s good to know which types of investments are at the higher end of the tax spectrum, so let’s review investment rates.

2018 Tax Rates: Gains made from investments such as municipal-bond interest are tax-free.

Highest Investment Tax Rates 

Most investment income is taxed at the highest rate: your federal earned-income tax rate. In 2019 this tax rate ranges from 10-37%, depending upon your total income. Investment income like bond interest and short-term capital gains (investments held less than 12 months) fall into this category. Anything you can do to reduce the tax on these investments can help save big money.

Lower Investment Tax Rates 

Long-term capital gains (gains from investments held longer than one year) are taxed at a lower rate—either 0%, 15%, or 20%, depending upon your total income. Lower overall income equals lower long-term gains tax.  

Tax-Free 

Then there's the nada-tax category. Gains made from investments such as municipal-bond interest are tax-free.

Extra Investment Tax for High-Income Earners

If your modified adjusted gross income is above $200,000 (for single filers), you also have an additional 3.8% tacked onto all your investment income. This is the Obama Net Investment Income Tax (NIIT) that went into effect in 2013.

Reducing Taxes by Changing Account Type

Sally's Trust Accounts

Sally had two investment accounts with a bank that was treating her accounts as trusts. Due to the regulations and detailed accounting that trusts require, Sally was paying $12,000 per year in taxes on these investments.  

After asking a few questions, Sally's advisor discovered these accounts were not really trusts at all. To her surprise, simply changing the account types cut her tax bill in half. Sally saved over $6,000 per year just by putting her money in the right type of account. 

Phyllis's Inherited Portfolio

Another example is the investment account of a widow, Phyllis. Phyllis's husband set up and managed their investments. After he passed away, Phyllis didn't touch the account for years. Although the fund was performing the same as any average investment, there was quite a bit of buying and selling going on within it. That active trading generated income—and a hefty annual tax bill.

After some planning, Phyllis's new advisor simply reallocated the investments to more tax-efficient accounts. Phyllis was able to maintain a similar return and significantly reduce her investment tax bill.

How to Save in Taxes? Take a Hard Look at Your Investments.

Step 3: Create Your Tax-Reduction Strategy 

The most effective tax-planning strategies are truly personalized. You can see from the tax tables and account types above that creating a tax plan around the specifics of your personal financial picture is critical for it to be effective at minimizing your tax bill. A CFP® will thoroughly review your tax return and investments alongside your financial plan to generate an investment tax plan.

While each investor’s plan will be different, below are the tax-saving opportunities we find most miss.

  1. Offset capital gains or investment income with losses (Schedule D). Average investors, even advisors, make buy/sell decisions without considering tax implications. Most investors also hold onto losing investments far too long (Read: Emotional Investing). Instead of holding a losing investment, sell it and use the loss to offset your gains and reduce your tax bill. You may carry a loss forward for up to three years after you sell it.  
  2. Offset income from passive investments or interest income with losses (Schedule E).  
  3. Hedge against tax increases. The federal income, gains, and dividends can impact your investment taxes. If you believe some or all of those rates will rise in the following year, you may consider selling some of your winning investments in the current year, in what would be a lower tax environment.  
  4. Switch from generating taxable interest to tax-free or tax-deferred. Consider interest from municipal bonds or annuities, which are often more tax friendly.
  5. Understand how often investments are traded in your mutual fund. Turnover ratio is the percentage of a mutual fund or other investment vehicle's holdings that have been "turned over" or replaced with other holdings in a given year (bought and sold). This activity can trigger tax, especially short-term capital gains, which are taxed at the highest, ordinary income rate. A turnover ratio of 100% means everything within that fund was sold within the year. Many funds have a turnover rate of 200-300% and are tax inefficient. Look into index funds, which typically have a lower turnover ratio.  

Step 4: Review Your Investments for Tax Efficiency Both Annually and When Major Life Changes Occur

Because tax codes and your fiscal situation are in frequent flux, your tax plan and investments should be reviewed twice annually in light of your financial plan. We recommend reviewing them at the beginning and end of every year. Changes in your income, your family situation, and your taxable gains can all impact your overall tax rate and, therefore, your investment taxes. 

Step 5: Tax Planning for Retirement 

In addition to more time for traveling and fishing, retirement brings a host of financial changes that can impact your overall tax rate and your investment taxes. While you might be losing job income, you'll be gaining Social Security and IRA required minimum distribution (RMD) income. Tax planning becomes critical to minimize your bill from Uncle Sam.  

Tax planning for retirement is especially important in the few years before and after you retire. Social Security can be delayed until age 70, and IRA RMDs aren't required until you are 70½. The goal is to time your income changes in a way that minimizes your income tax bracket every year and, therefore, your investment tax rate.  

For example, say you retire at age 65 and your job income drops to zero. You choose to delay Social Security until you’re 70. For the next 5½ years, before you’re required to pull RMDs, you could draw from your IRA for income, at the lowest tax rate, while you don’t have the other income. This would effectively lower the income from your RMDs when you are forced to take them.

Step 6: Create a Personalized Tax Plan 

I think you can see that, just with investments, it takes a bit of proactive planning to minimize your taxes. If you don't have an overall, personalized tax plan, chances are you're leaving money on the table. A CPA who does tax planning or a CFP® knowledgeable about investment taxes can work with you to create a proactive plan. The best time to start is just after your taxes are filed for the previous year. 

The Bottom Line 

Tax efficiency within your portfolio is a wealth-building opportunity that most investors miss. Streamlining your investments can help you keep more of your earnings and stay out of a higher tax bracket. Given the markets' persistent volatility, your decisions regarding tax-efficient investing may spell the difference between reaching and falling short of your financial goals. 

Let's Talk

If you’d like to explore ways to reduce portfolio risk, let’s chat.

We’re pleased to offer a complimentary tax-management consultation, either over the phone or in person. 

complimentary investment management consultation in Napa Valley & Walnut Creek, California.

Related Article: 11 Elements of an Effective Tax Savings Plan

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Related Article: Charitable Giving Strategies to Maximize Your Deductions


Categories: Tax Management, Tax Strategies, Lower Taxes, Tax Savings, Tax Planning, Tax Minimization, Charitable Giving Strategies 


This is a hypothetical situation based on real-life examples. Names and circumstances have been changed. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments or strategies may be appropriate for you, consult your financial advisor prior to investing. This information is not intended to be a substitute for specific, individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. 
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