Tax-Smart Investment Strategies

Mike Miroballi for the Wall St. Journal writes: Our firm released a survey regarding Americans’ confidence in tax planning. While the vast majority of people who do their own taxes feel confident in doing so, the survey showed that when you dig a little deeper, most people don’t know a lot about tax-smart investment strategies and solutions.

For example, less than half of respondents understood the tax treatment of capital gains, or how dividend income is treated from a tax perspective. At the end of the day, if you don’t manage your money in a tax efficient way, your ability to accumulate wealth will be stunted.

Advisers need to help clients become more knowledgeable about tax-smart investment strategies. Don’t assume clients know the tax code. They’ve got a lot of other things on their minds.

Advisers should remind clients of the importance of positioning assets. Putting your least tax-efficient investments in your tax-advantaged accounts like IRAs makes a lot of sense, especially if you don’t need that income immediately.

Advisers should also remind clients to maximize the tax benefits available through tax-deferred accounts. I know it sounds fundamental, but I can’t tell you how often I come across clients who aren’t maximizing the tax-free contributions to their 401k plans.

Advisers should also be familiar with the state-by-state rules for tax-friendly investment vehicles like 529 education savings plans. In some states, if a client is saving for a college education, they can get a tax deduction for contributing to their in-state 529 plan.

As you approach the end of a calendar year, understanding where a client stands relative to capital gains is also important. There may be an opportunity to harvest a loss in a security that hasn’t performed well. If it is worth less than what was invested, the client can offset any capital gains with that loss by selling the security before the end of the year.

Knowing the difference between long-term and short-term capital gains is another basic strategy that clients often overlook. Whereas securities held for less than one year are taxed as ordinary income–up to 39.6% for the highest-income individuals–securities held longer than one year can only be taxed at a maximum of 20%. If you have a decision about whether to hold a security for less than or greater than 12 months, that can literally cut that the tax obligation in half.

For clients who are purchasing mutual funds, advisers can help them understand when those funds will distribute their capital gains. If you’re a holder of record, you’re going to be taxed on any capital gains, regardless of whether you actually earned those returns or not. Sometimes it makes sense to defer that purchase until after the capital gains have been distributed.

The best advisers I know aren’t providing mind-blowing tax-saving information. It is usually basic. But they bring it to light. Often times, from the adviser’s perspective, it is a matter of communication.