Make Your Portfolios More Tax Efficient

We are in the midst of tax season so this is a good time to review your portfolio to make sure it is arranged in the most tax-advantaged way.

Most investments (bonds, bond mutual funds and ETF's) that generate interest work best in a tax-deferred account.

Muni bonds are an exception as their interest is exempt from federal taxes and in many cases, exempt from state taxes as well. Hold municipal bonds in your taxable accounts.

Stocks, usually long term investments, should be held in your taxable account for several reasons:

1. long-term capital gains on stocks are taxed at a maximum 20%. Most folks will pay less, 15%. That is certainly a better rate than 25% - 30% regular income as it would be taxed from an IRA or 401K distribution.

2. losses in your taxable account can be used to balance any gains you realize. Losses cannot be taken in a tax-deferred account.

3. qualified dividends from stocks are taxed at 20%. These same dividends in a tax-deferred account are added into the overall distributions and are taxed as ordinary income - 20% -37%.

4. you may donate stock that has grown significantly to charity avoiding any capital gains tax.

5. you may pass appreciated stock on to your heirs at your death. This will give them a step-up in basis (which means the cost basis of the stock - what you paid for it - will now be the value of the stock on the day you died.) If they sell the stock immediately there will be little or no capital gains tax.

Roth IRA's are different!!
All contributions to Roth IRA's are after tax.
Distributions from a Roth are tax-free, so holding both stocks and bonds in a Roth is fine. The one problem is that you may not take a loss on any stock that may have fallen in value.

Be $ Smart - be aware of how dividends, interest and capital gains are taxed so you may position your portfolios in the most tax-efficient way. You keep more money in your pocket and less in Uncle Sam's.

Another Type of Diversification

Over the past few weeks we have talked about diversification within your portfolio. We use diversification to reduce potential risk. Another kind, tax diversification, occurs with the types of accounts in which you hold your assets and how withdrawals are taxed.

No matter how you make your money, Uncle Sam is waiting to take his share. You can structure withdrawals to be tax efficient and lower your tax burden. This is especially effective during retirement. For you to have income choices you must build these accounts prior to retirement, while you are young and in the "accumulation" phase of your life.

A well diversified portfolio will hold a mixture of assets - stocks, bonds, cash, real estate, precious metals, etc. Creating a tax-diverse portfolio means you hold assets in taxable, tax-deferred and tax-free accounts.

A trained advisor will scrutinize a retirement plan for tax efficiency. You want to minimize taxes by taking income from specific accounts.
Remember, money held in tax-deferred accounts (traditional IRA, 401k,etc.) is fully taxed as ordinary income on withdrawal paying both state and federal taxes.

If all your assets are tax-deferred, every withdrawal will count as income and could push you into a higher tax bracket. For example, say you need $60,000 a year for income, you must withdraw $72,000 to cover the 20% withholding. Add that to Social Security or pension income, you could bet bumped into the next tax bracket. But, if you could take $40,000 ($48,000 less 20%) from the IRA, $10,000 from your taxable account(paying some capital gains tax) and $10,000 from your Roth (tax-free), you maintain a lower taxable income.

Be $ Smart - build your savings in different types of accounts for tax efficiency.

Be sure to consult your tax advisor for specifics.