Portfolio Tax Planning 101

Understanding how your investments are taxed is an important part of building a successful portfolio. The IRS loves getting paid, so it’s difficult to completely avoid taxes. However, if you know how your investments are taxed, you can make sure to pay as little as possible while maximizing your take-home portfolio value.

A major factor in portfolio taxation boils down to asset location. While it may sound complicated, asset location simply refers to the types of accounts you own. There are many different types of accounts, but we can lump them into three major categories: taxable, tax-deferred, and tax-exempt. 

Taxable

With a taxable account, you pay taxes each year based on the gains, losses, and income generated from your portfolio. For example, let’s assume you bought a share of Amazon stock earlier in the year for $2,000 and sold it a few months later for $3,000, locking in a $1,000 profit (not too shabby). Though the gain is nice, you would be responsible for paying taxes on the $1,000 profit you just realized (more on the different types of gains in just a bit). Furthermore, if Amazon paid a dividend (they don’t currently, but maybe someday), you would also owe taxes on the dividends received. Taxable accounts include Individual/Brokerage and Joint accounts.

Since you can be liable for paying taxes on a regular basis when using taxable accounts, it is important to understand some of the basic characteristics regarding various taxable events. 

• Long-Term Capital Gains occur when you sell an asset, such as a stock, for a profit after holding it for over 12 months. To encourage you to hold on to your investments for longer periods of time (over 12 months) the taxes on long-term gains taxes are lower than regular income taxes.

• Short-Term Capital Gains occur when you sell an asset for a profit after holding it for less than 12 months. Since the holding period was for a short time frame, there aren’t any favorable tax incentives when selling the asset. Short-term gains are taxed at your ordinary income tax rate. 

• Dividends from stocks can be taxed differently depending on if the dividend is qualified or non-qualified. To be a qualified dividend, the dividend must be paid by an American company or qualifying foreign company, the IRS must not recognize the dividends as non-qualifying, and a specified holding period must be met. If dividends are considered qualified, they will be taxed favorably at the lower long-term capital gains rates. Non-qualified dividends are taxed at ordinary income rates just like short-term capital gains.

• Interest Income from bonds is much easier to classify than dividend income. Interest income is simply taxed at your ordinary tax rate just like short-term capital gains and non-qualified dividend income.

• Mutual Fund taxes are passed through to the investor. When the fund receives dividends/interest, or when the fund sells shares of its individual investments for a gain, the tax consequences are passed on to you. You are taxed as if you experienced a capital gain or dividend income as the fund buys and sells investments. Even if you continue to hold a fund for a long time and do not make any additional purchases or sales, you may still be liable for paying taxes based on the investment activity within the fund. 

Tax-Deferred

Tax-deferred accounts, as the name implies, allow you to defer taxes. Typically with tax-deferred accounts, you make contributions prior to any taxes being withheld and are not required to pay any taxes until money is actually withdrawn from the account. Using the same example as above, you would not owe anything to Uncle Sam yet when you sold Amazon for a $1,000 profit (or if you received a dividend). The gains are deferred into the future until you take a distribution. Common types of tax-deferred accounts include 401(k)’s and Traditional IRA’s.

Tax-Exempt

Tax-exempt accounts are also tax-advantaged, but differ from tax-deferred accounts regarding when taxes are paid. With a tax-exempt account, you pay taxes on the contributions made into the account on the front end, and the funds can grow and be withdrawn tax-free. This means you won’t owe any taxes when you sell a stock for a profit or receive dividends. As the major difference lies in the timing of when taxes are paid (whether up front or on the back end), there are some important factors to consider when choosing between tax-deferred and tax-exempt. Roth 401(k)’s and  Roth IRA’s are common tax-exempt account types.

While there are plenty of additional areas that merit discussion from a tax planning perspective, such business taxes and estate taxes, a solid portfolio tax planning strategy can be a major contributor to achieving a higher net worth during your lifetime.

Taxes can be a scary subject due to the complexity involved, but having a general knowledge of how your investments and account types are taxed can help you build a more efficient portfolio. Though it may not seem like a major contrast in any given year, small tax savings can add up and compound over time, making a notable difference to your ending portfolio value over the long-run. 

Derek Prusa, CFA, CFP® and Ben Webster, CFP®

Co-Founders and Owners of Aspire Wealth