When establishing an investment portfolio, the focus is often on achieving your short- and long-term financial goals. This may include creating a nest egg for retirement, generating the money needed to pay for some of life’s major expenses, or even establishing a reliable, passive stream of income that can be accessed long before retirement.
The one thing that may not be top of mind is tax strategies related to your investment portfolio. But this, too, is important, as there are many steps you can take to minimize or entirely eliminate tax liabilities associated with your investments.
Wealth advisor’s tips to minimize tax events on your investments
To help readers navigate the tax liabilities associated with investing we reached out to some of the industry’s top wealth advisors. The experts we spoke with represent Schwab Center for Financial Research, Wells Fargo Wealth & Investment Management, and J.P. Morgan’s Wealth Management’s Wealth Planning and Advice team.
But before diving into the actionable tips from these advisors, it’s important to understand the two primary ways stock investments can trigger a tax event with the IRS. The first is when you receive dividends or interest payments from your stocks—which is considered taxable income. And the second is capital gains, which involves selling an investment for more than its initial cost you paid.
“Capital gains are a profit earned on your investment,” says Sarah Daya, of J.P. Morgan Wealth Management’s Wealth Planning and Advice team. "The amount you purchase your stock investment for is your cost basis. When you sell your stock at a price higher than what you paid for it, that difference is your capital gain amount.”
In the eyes of the IRS, that profit or capital gain is considered income and thus subject to taxes.
The key point to understand however, is that as an investor, you can proactively make decisions or take actions to limit some tax events, but not all of them. Investors can’t generally control when they receive a dividend or interest payment for instance. But it is possible to exercise some control over capital gains, based on when you choose to sell. There are also other ways to minimize or eliminate taxes.
Here are four tips from wealth advisors to keep in mind.
1. Avoid excessive trading
Tip number one from wealth advisors is to avoid excessive trading of investments. Another way to think of this is following what’s known as a buy-and-hold investing strategy that minimizes tax events.
The IRS taxes investors more heavily for selling stocks within one year or less of purchase. The tax burden is reduced for those who hang onto stocks longer.
“To the extent that the investment is held for longer than one year, the appreciation would be taxed at the long-term capital gains rate, which is likely to be either 15% or 20%, depending on the investor’s total taxable income level,” says Jesse Little, senior director of advice for at Wells Fargo Wealth & Investment Management. “If the investment is held for one year or less, any capital gain realized upon sale is considered to be short-term and is taxed as ordinary income to the investor.”
Translation: When possible, hold investments for longer than one year in order to minimize the taxes you pay.
And a bonus tip on this front: The buy-and-hold strategy is particularly appropriate for institutional investors who have a very long investment horizon and do not need to be as concerned with volatility in the market that may impact the value of individual assets.
"Investors are only taxed on capital gains when they sell an investment in a taxable brokerage account. Until they sell, the gains continue to grow without tax. This presents a powerful planning opportunity, for long-term investments," says Hayden Adams, CPA, certified financial planner, and director of tax and financial planning at Schwab Center for Financial Research. "This can be an effective way to defer taxes on investments in taxable brokerage accounts, in a similar way to deferring taxes on investments in 401(K)s and retirement funds."
2. Practice tax-loss harvesting
The next tip wealth advisors offer is this: consider tax-loss harvesting, which can be a powerful way to offset tax burdens. This technique involves selling select investments at a loss with the aim of offsetting the gains you may have realized as a result of selling other investments at a profit.
“While at first blush it may seem counterintuitive, tax loss harvesting first requires that an investor sells [some] securities at a value that’s less than the cost basis in order to generate a loss,” explains Emily Irwin, managing director of advice for Wells Fargo Wealth and Investment Management.
These losses can then be used to offset the amount of capital gains tax that would otherwise be owed because of the sale of other securities that were sold.
When considering this tactic, it’s important to understand a few key points. To begin with, tax loss harvesting cannot be used to reduce taxes on ordinary income, just investment income. In addition, a security must actually be sold to create the loss—it cannot simply have decreased in value within an investor’s portfolio, says Irwin.
In addition, while it is entirely possible to implement tax loss harvesting to offset both short-term and long-term capital gains, it can be especially advantageous to use this approach for short-term asset sales as they are subject to higher tax rates.
“Short-term capital gains are taxed at ordinary income tax rates, as compared to long-term capital gains, which are taxed at 15% or 20%, depending on the investor’s total taxable income level,” adds Irwin.
3. Save for retirement using tax-advantaged accounts
Tip number three is to put some of your money into tax-advantaged investment accounts. This could include 401(k) accounts, 403(b) accounts, and IRAs—which are often referred to as tax-advantaged accounts.
“Tax-advantaged accounts are generally categorized as either pre-tax or tax-deferred investment accounts, or after-tax investment accounts,” explains Little. “Pre-tax accounts allow an investor to defer tax payments on contributed amounts until a later date. After-tax accounts are funded with contributions the investor has already paid taxes on, but earnings on the investments in the account are not taxed subsequently.”
Here are some of the tax-advantaged account options to consider.
401(k) retirement accounts
Many employers offer 401(k) retirement savings plans, and these plans offer significant tax benefits. With a 401(k), you can select a percentage of your income to be automatically deducted each pay period and invested in your retirement account. The money is deducted from your salary on a pre-tax basis.
“Because your contributions are withdrawn from your paycheck before you’ve paid any taxes, your taxable income will be lower,” says Daya.
The employee annual contribution limit for 2022 is $20,500. Employees who are 50 or older can contribute an additional $6,500 as a catch-up contribution. Money withdrawn from your 401(k) during retirement will be taxed at the tax rate you’re subject to then, which may be lower depending on your circumstances.
403(b) retirement accounts
Individuals who work for non-profit organizations or in the public sector may have access to a 403(b) retirement account. These plans are similar to 401(k) accounts in that the contributions you make are pre-tax, thus lowering your tax liability today. And also, similar to a 401(k) plan, distributions will be taxed at the rate in effect when the withdrawal happens.
“Investing in a 403(b) offers a tax-advantaged way to save for retirement and build wealth for the future, but the investment options available in a 403(b) may be more limited than what is available in 401(k) plans,” says Daya.
IRAs
An Individual Retirement Account (IRA) is a tax-advantaged investment account that’s designed to help individuals save for retirement. Unlike 401(k) accounts or 403(b) accounts, they’re not offered by employers and are typically opened with a bank or brokerage firm.
There are two primary types of IRAs—traditional and Roth. Each offers benefits. For instance, traditional IRAs are funded with pre-tax dollars, meaning they reduce your income tax for the year that you make the contributions.
“Anyone can create and fund a traditional IRA, which is another type of tax-deferred account,” says Little. “Contributions made by investors who are younger than age 72 ½ and who earned taxable income in the year of contribution are generally deductible on their tax return.”
The annual contribution limit for traditional IRAs is $6,000 for 2022, with an additional $1,000 contribution limit available to individuals who are over the age of 50.
Roth IRA contributions are made after-tax and are thus not tax deductible for your annual income tax bill. But you will not be taxed on the distributions from this type of IRA. Some of the additional benefits associated with a Roth IRA include the fact that contributions can be made to a Roth at any age, and they are not subject to the required annual minimum distribution rules that many other retirement accounts must adhere to.
4. Donate stocks to charities
One last tip that can both help minimize your taxes and help others in the process: consider donating stock to charities—as opposed to cash. Here’s why.
When investors donate appreciated stock that’s been held for longer than one year to a public charity, then neither the investor nor the charitable organization is taxed on any capital gains.
"For those who are charitably inclined, giving appreciated long-term assets is a great way to maximize the tax benefits of making donations," says Adams. "That’s because when you give long-term appreciated assets, you don’t have to recognize a taxable capital gain, but you still are able to receive a charitable donation deduction, assuming you itemize."
The donor is eligible to receive a deduction for the fair market value of the donated stock up to 30% of the investor’s Adjusted Gross Income (AGI). And any amount over the 30% threshold is a carryover deduction for five years.
Contrast this with the alternative of selling the stock first, paying capital gains tax on the sale, and then donating the net proceeds to charity and the benefit of simply donating the stock itself becomes obvious. “By simply donating the stock directly to the charity, the investor can make a greater financial impact to the intended charitable mission,” says Irwin.
The takeaway
There are many ways to proactively manage the tax exposure associated with your investment portfolio and this effort does not have to be complicated. Following some of the tips from wealth advisors including implementing a buy and hold strategy, tax loss harvesting, and tax advantaged accounts, can help keep more money in your pocket. And one last bit of parting advice from the experts: It’s important to regularly assess your tax exposure, making it a part of your ongoing financial routine.
“Don’t make managing your potential tax exposure a once-a-year activity,” says Irwin. “By regularly reviewing your investment portfolio…an investor may find opportunities throughout the year—especially during periods of market volatility—to implement strategies that ultimately will reduce the tax bill.”
