How Does Tax Planning Impact Investment Returns?
Tax planning is the secret ingredient in the intricate recipe of investment returns, transforming a good portfolio into a great one. Explore five insights, beginning with the art of tax-loss harvesting, that shed light on different aspects of tax planning and its significant impact on investment outcomes.
- Utilize Tax-Loss Harvesting
- Manage Your Investment Portfolio
- Maximize Investment Returns
- Plan For Long-Term Growth
- Optimize Asset Location
Utilize Tax-Loss Harvesting
As one of those critical elements that can have a profound effect on your investment returns, it's important to pay close attention to tax planning, especially in the realm of timing investment sales and purchases. Of all the factors to consider when selling a stock or other investment, the tax consequences related to capital gains are the most likely to have a big impact on your bottom line. As a Certified Financial Planner, I'm always telling clients to be tax-aware. Selling investments in a strategic manner can make a big difference in your taxes paid, especially if you make good use of tax-loss harvesting.
One way of doing this is by using tax-loss harvesting. In this strategy, you sell an investment that has generated a capital loss in order to offset capital gains tax on some profits. So if you've made a profit on some stocks, but the others in your portfolio are dogs, selling the losing investments reduces your taxable income. This strategy lowers your tax liability for the year and also rebalances your investment to more profitable opportunities. The timing of these sales is vital and must be carefully coordinated with your tax situation. You need to evaluate how the market is doing and what you think is going to happen to your investments. If you're smart about it, you can turbocharge your effective returns after-tax. This strategy takes some planning and a good understanding of the market and the tax law, but if you get it right, you can save a lot on taxes, and therefore, your effective returns on your investments will be that much higher.
Manage Your Investment Portfolio
Tax planning has a significant impact on investment returns. Tax management of your investment portfolio is one of the aspects that you have total control over with your investments. You can't control whether the markets or your investments go up or down, but you can utilize those movements to gain tax alpha. Capturing down-moves on an ongoing basis to offset gains will impact how much you keep at the end of the day. As the old saying goes, it's not how much you make but how much you keep that matters.
Maximize Investment Returns
As someone who has spent decades navigating the intricate world of taxes, I can tell you with confidence that tax planning is a critical component of maximizing investment returns. It’s not just about how much you earn but how much you keep after taxes.
Effective tax-planning strategies can lead to significant savings, which in turn can be reinvested to yield even greater returns over time. For example, understanding the implications of capital gains tax and employing tactics such as tax-loss harvesting can make a substantial difference.
At the Tax Crisis Institute, we prioritize the protection of financial assets through strategic tax planning, ensuring that your hard-earned investments remain as fruitful as possible. Employing expertise in tax laws and regulations enables us to craft bespoke plans tailored to individual circumstances, which is the cornerstone of safeguarding your financial growth.
Plan For Long-Term Growth
Timing is critical, too. Holding on to investments for more than a year can reduce the tax rate you pay, as long-term capital gains are taxed more favorably. Additionally, contributing to retirement accounts like 401(k)s and IRAs can reduce your taxable income now, while allowing for tax-deferred or tax-free growth, which is a huge benefit over time.
If you’re thinking long-term, converting traditional IRA assets to a Roth IRA may offer tax-free withdrawals in retirement, further enhancing your returns. And when you retire, the order in which you draw from different accounts can make a big difference in managing taxes efficiently.
Lastly, keeping an eye on tax credits, deductions, and changes in tax law is crucial. These elements can all lower your tax liability and help you maximize your after-tax returns, especially when considering estate planning to minimize taxes on assets passed to beneficiaries.
Optimize Asset Location
Tax planning can have a tremendous impact on the outcome of a financial plan.
For example, financial planners who are in the know will use "asset location" in their strategies, thereby placing investments across portfolios based on the taxability of the portfolio on that type of investment. Investments that produce income in tax-deferred accounts, growth investments in tax-free accounts, and using tax-favored bonds/growth stocks in taxable accounts.
When we do not implement "asset location," we may be paying regular income taxes on capital gains (which could cost thousands) as opposed to capital gains taxed at a lower rate, and getting reduced growth rates in our tax-free accounts (opportunity cost). These extra taxes reduce our net investment return.
Converting from pre-tax to Roth during a down market in a low-tax year can multiply tax-free returns drastically while lowering your lifetime tax bill, equating to a higher net investment return.
