Introduction and Benefits
Tax-efficient investing structures your portfolio to maximize current tax law benefits, reducing taxes, and increasing your net worth. Over time, as individuals invest the tax savings and earn additional returns, there is a compounding effect. Hemispheres Investment Management crafts individual investment strategies to meet client goals and utilizes tax mitigation in its Global Equities product.
Tax-Efficient Investment Accounts
Most people are familiar with retirement accounts, but other investments also offer tax advantages. We will discuss some of these below.
401(k) and 403(B) accounts
The IRS established these tax efficient instruments to encourage individuals to save for retirement. Investors make contributions into employer-sponsored accounts pre-tax, reducing taxable income by the amount of the contribution. The dividends, interest and capital gains in the account grow tax free until the employee withdraws funds. Fund withdrawal typically occurs upon retirement. The employer-sponsored fund offers an additional benefit: employers often make matching contributions that enhance your returns. For 2024, the IRS raised the contribution limit to $23,000, with an additional $7,500 for individuals over 50.
Traditional Individual Retirement Accounts (IRA)
Individual contributions into an IRA function identically to the 401k in that the pre-tax contributions reduce your taxable income and the dividends, interest and capital gains in the account grow tax free. At 70.5 years of age, the IRS requires individuals to begin withdrawing minimum distributions that are taxable. At the age of 70.5, the IRS requires minimum taxable withdrawals based on an actuarial table of life expectancy. Failure to make the correct distribution results in a tax penalty.
The 2024 contribution limit into the IRA is $7,000 if you are under 50 and $8,000 if you are over 50. While there are no income limits for contributing to a traditional IRA, deductions may be limited if you also participate in an employer-sponsored plan.
Spousal IRA
If you file a joint return and live in the same residence, you can contribute to an IRA up to the limits even without earning income, as long as your spouse’s taxable income exceeds the combined IRA contributions.
Roth IRA and Roth 401(k)Accounts
Roth IRAs function differently than traditional IRAs and 401(k) accounts. While the contribution dollar limits remain the same as the traditional counterparts, you make the contributions after-tax. The real benefit of these accounts is that the investments grow tax-free, you don’t pay taxes on distributions in retirement, and you don’t have to worry about a required minimum distribution. The IRS does phase out the amount of allowable contribution to a Roth account based upon income level.
Various Programs to offset Health Care Costs
The IRS designed several health savings plans are to offset medical expenses for individuals and families without health insurance or who have high deductible health plans. The most common plan is the Health Savings Account. Investments grow tax free, and withdrawals are tax exempt if you use the funds for qualified medical expenses.
529 Plans and State Education Plans
A 529 plan provides federal tax advantages to cover educational expenses. Investments grow tax-free, and withdrawals are tax-free if used for qualified educational expenses. State-sponsored educational plans are available with their own requirements and tax benefits.
Tax-Efficient Government Issued Securities
The US Treasury issues a series of bonds, such as Treasury Bills, Treasury Bonds, Treasury Notes, I-Bonds (pegged to inflation rates). These bonds are subject to federal taxation but are exempt from state and local taxes.
State and local governments issue Municipal bonds. Federal income taxes do not apply to municipal bonds, and these bonds can also be exempt from state and local taxes if you live in the locality where the bond was issued.
Taxation of Fixed Income Securities vs. Equities
The government taxes the interest payments on Fixed Income Securities (Bonds) as ordinary income. Holding a bond until maturity results in repayment at the original principal value. There is no capital gain or loss in this event. If you sell the bond before maturity and its value differs from the principal value, you will incur a gain or loss. If you hold the bond for more than one year, it qualifies for capital gain/loss treatment for tax purposes.
The government similarly taxes equities on income and gains upon the sale of the security. If you hold securities for longer than one year, gains or losses receive capital gain/loss treatment for tax purposes. If you hold them for less than one year, the government treats the gains or losses as ordinary income/loss. Dividends can be either qualified or ordinary. The determination of whether the dividend is qualified or ordinary is based upon holding period. The government considers a dividend qualified if the shareholder owns the stock for more than 60 days in the 121-day period that begins before the ex-dividend date. Most US corporations qualify, and most foreign corporations also qualify for this favorable tax treatment if they are readily tradable on US securities markets or benefit from a comprehensive income tax treaty with the US.
Other Tax Efficient Investing Strategies
Tax-Loss Harvesting
Investors typically engage in tax-loss harvesting near year-end by selling investments at a loss to offset taxable gains from profitable investments. This strategy involves loss deduction limits and adherence to wash sale rules if reinvesting in the same security sold at a loss.
Passive ETFs
Passive Exchange Traded Funds (ETFs) are designed to mirror the benchmark and are neither actively managed or traded. As such, passive ETFs generally do not generate material taxes until the investor sells the security. A capital gain or loss is recognized at the time of the sale.
Other Tax-Related Investment Considerations
Portfolio Rebalancing – Portfolio Managers periodically rebalance client portfolios to maintain the desired asset allocation, mitigate risk, and optimize return potential. When an investor takes profits by selling winners, it could create a tax liability and create a tax drag on taxable accounts.
Impact of Estate Planning or Philanthropic Goals on Portfolio Strategy
Generally, it is preferable to have assets designated for estate planning or charitable giving in a taxable account. Highly appreciated assets receive a step-up basis for heirs at the time of account holder death. The appreciated assets provide larger tax deductions for charitable giving purposes.
Risks Associated with Tax-Efficient Investing
The IRS rules are complex and can change frequently so expert guidance is essential. We recommend seeking an Estate Planning Attorney, CPAs, and Investment Managers who understand your specific needs and goals.
Conclusion
There is no panacea that will eliminate your taxes while you earn investment returns. The best solution is to hire an investment manager with a proven track record of success in achieving client goals, including tax-efficient strategies.
The investment principles at Hemispheres Investment Management each have over 35 years of experience managing portfolios, including for highly tax sensitive investors. Hemispheres garnered its experience over multiple market cycles and various watershed events. Hemispheres has developed a proven and repeatable investment process with demonstrated investment results. We encourage you to contact us for a free consultation. We can assist you develop an asset allocation that is appropriate for your needs and goals. Please feel free to book a free consultation with us.
