When I started my investment career at Wells Fargo sixteen years ago, investors who were concerned about the impact of taxes on their investment returns in taxable accounts were typically heavily invested in tax-free municipal bonds. Today, investors can consider additional investment options. New tools and technologies assist your investment manager’s efforts to manage your portfolio’s tax exposure, helping to reduce the potential of a nasty surprise at tax time.
Let me give you a couple of examples of why taxes could trip you up:
- It is important to consider how dividends are taxed. Qualified dividends are taxed at long-term capital gain rates. Nonqualified dividends, including payouts from Real Estate Investment Trusts and other unearned income, are taxed at ordinary income tax rates. Higher income taxpayers also may be subject to a potential surcharge on unearned income.
- Timing in purchasing a mutual fund also can have unintended tax consequences. Most mutual funds pass earnings to their shareholders towards the end of the year. You will need to report distribution from the fund for the whole year on your tax return, even if you purchased the fund just prior to the distribution. High portfolio turnover within the fund also can trigger higher taxes.
The long and short of investments and taxes is that if you’re not careful, your tax bill may be higher than you anticipated depending on the types of investments you own. So to keep it simple, are you better off investing only in tax-free muni bonds to manage your taxes? The answer is not necessarily.
Despite the differences in the way in which they are taxed, you and your advisor may have decided that investments such as REITs are an appropriate addition to your portfolio based on your investment objectives. You also may decide that the timing of buying a mutual fund makes more sense just before a distribution rather than waiting until it likely will not have a tax impact. The tax tail shouldn’t wag the investment strategy dog.
Don’t get me wrong: I am not saying that you shouldn’t consider investing in tax-free municipal bonds. In fact, even though COVID-19 has increased the risks to this bond sector as municipalities face financial challenges, we think that market conditions are favorable for investors; tax-free muni bond supply is low and demand is growing. My point is, consider owning them as part as of a well-diversified portfolio in your taxable accounts.
So what should you be discussing with your advisor if you want to help ensure that you’re making tax planning a year-long exercise?
- Review your portfolio with your advisor to make sure that it’s aligned with your investment objectives — remember, that taxes are a consideration but shouldn’t drive your investment decisions
- If you are unsure about the investments you own, ask for additional information
- If you are concerned about your tax exposure, ask about tax-advantaged portfolios
