A Checklist for Retirement Planning
Written by Jason Hiley
Written by Andrew Hunt
Last year crept to a close and the new year means “tax season” is on a lot of people’s minds. But thinking about your income taxes shouldn’t be confined to one short time period of the year. The best way to minimize your tax liability is to engage in year-round tax-wise investing. To do so, you must consider your personal investment habits and the tax efficiency of individual investments.
Tax-efficient investing starts with you. There are several personal habits you can embrace that make for smart tax-wise investing. Here are a few ways to get started.
It’s such a simple adage, but if you invest according to plan, specifically in the form of a written Investment Policy Statement, everything we are about to explain will be easier to accomplish. By clearly defining and documenting what you plan to achieve with your investments and how you plan to achieve it, you and your financial team are best positioned to ignore the inevitable, often tax-incurring distractions along the way. A detailed investment plan also serves as your reliable guide for resolving any conflicting priorities when balancing tax efficiency versus other considerations within your overall wealth management.
Simply put, the more trading you do in your taxable accounts, the more “opportunities” you create to be taxed on the proceeds. The fewer trades that are required to accomplish your investment plan, the better off you’re likely to be when taxes come due.
The more assets you can hold in tax-sheltered or tax-free accounts such as IRAs, Roth IRAs, 401(k)s, 529 college saving plans, and health savings accounts (HSAs), the more opportunities you have to avoid or at least postpone the tax ramifications otherwise inherent in building capital wealth.
Next, consider your individual investments. For example, let’s say that your investment plan calls for holding a diversified mix of domestic and international stocks in your taxable accounts. Unless you’re planning to invest directly in thousands of individual securities (which we generally advise against), you will need to choose one or more funds to make up the desired mix. That’s where the challenge begins because even if two funds share identical investment objectives, one may be considerably better than the other at tax-efficiently managing its holdings on your behalf.
It’s easy for fund managers and investors to ignore this important detail because not all dollars lost to a fund’s tax inefficiencies show up in its published returns. Some of them may show up as annual capital gains distributed to fund shareholders (i.e., you), who must pay taxes on the gains at their individual tax rate – whether or not the share value of the fund itself has gone up, down, or sideways.
To minimize such scenarios and otherwise soften the blow of your fund’s taxable trading activities, it’s worth seeking out managers who exhibit best tax-management practices, especially for funds that you plan to hold in your taxable accounts. Below are some traits to look for.
Just as you should minimize your own hyperactive trading, your fund managers should do the same by heeding the academic evidence on how markets operate. Most managers try to “beat” the market by actively picking individual stocks or forecasting when to be in or out of it. Instead, look for managers who are seeking to build lasting value by patiently participating in the long-term growth expected from the return factors being targeted. Evidence-based investing is not only a more sensible overall approach, it also is typically more tax-efficient.
As implied above, it’s best to invest in funds in which your fellow shareholders are less likely to panic-sell during bear markets. Undisciplined investors may force a fund manager to liquidate appreciated holdings to fund their flight, incurring distributed capital gains that you, as a fellow shareholder, must shoulder along with them. Investors who form personal investment plans adopt an evidence-based strategy and choose like-minded fund managers to help them implement their plans should be better at retaining their resolve, even during volatile markets.
Some fund families offer versions of their evidence-based funds that are deliberately tilted toward favoring tax-friendly trading over maximizing gross returns with no regard to the taxable consequences. Tax-friendly trading can include practices such as avoiding incurring short-term (more costly) capital gains and more aggressively realizing available capital losses to offset gains
Follow these basic best practices when it comes to your investing and you will be well on your way to making tax-wise investments. As always, for specific advice you should engage with a tax professional and nothing in this article should be relied upon as tax counsel. If you’d like to learn more about how we can help you with your own tax-wise investing, contact us today.