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Taxes and your investment returns

Considerations for helping to manage your portfolio’s tax exposure.

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.

Michelle X. Wan

Michelle X. Wan

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
Michelle X. Wan is an investment strategy analyst for Wells Fargo Investment Institute.

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Talk to us about crafting strategies for managing both sides of your balance sheet.

Wells Fargo Investment Institute, Inc. is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A.

This article has been prepared for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Individuals need to make their own decisions based on their specific investment objectives, financial circumstances and tolerance for risk. Please contact your financial, tax and legal advisors regarding your specific situation and for information on planning for retirement.

All investing involves risk including the possible loss of principal. Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve.

Diversification does not guarantee profit or protect against loss in declining markets. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.

Stocks may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Dividends are not guaranteed and are subject to change or elimination. Bonds, including municipal bonds, are subject to interest rate, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates.

Real estate-based investing: There are special risks associated with an investment in real estate, including credit risk, interest rate fluctuations, and the impact of varied economic conditions.

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