Tax-smart investment strategies you should consider

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While taxes shouldn't necessarily drive your investment decisions, they are an important consideration.
While tax rules and rates may change over time, the value of keeping taxes in mind when making investment decisions does not. The reason? Taxes can reduce your investment returns from year-to-year, potentially jeopardizing your long-term goals.
The higher your current income tax rate, the more beneficial it may be for you to consider the impact of taxes when making changes to your investments. Be sure to consult with your professional tax advisor before making any decisions that could affect your taxes.
Here are six strategies that can help maximize your tax efficiency.

1. Contribute to tax-efficient accounts

Take advantage of tax-efficient retirement accounts for which you're eligible to help reduce current and/or future taxes.
Current income tax impact
  • Traditional IRA contributions may be tax deductible
    • Your total annual contribution to traditional IRAs and Roth IRAs is subject to a dollar limit
    • Your deductible contribution to a traditional IRA may be limited if you (or, in some cases your spouse) are an active participant in an employer-sponsored retirement plan, such as a 401(k), and your income exceeds certain thresholds
  • Traditional 401(k) contributions are made pre-tax, reducing your current taxable income, and are subject to annual contribution limits
  • Roth IRA and Roth 401(k) contributions are made on an after-tax basis and are subject to annual contribution limits. Roth IRA contributions may be limited depending on your income level
Future income tax impact
  • Traditional IRAs and 401(k)s offer tax-deferred growth potential
  • Roth IRAs and Roth 401(k)s offer tax-free growth potential

2. Diversify your account types

Using a combination of investment account types lets you mix and match income sources in retirement to help minimize your taxes.
Different investment account types offer different tax treatments
  • Traditional IRAs and 401(k)s offer tax-deferred growth potential
  • Roth IRAs and Roth 401(k)s offer the potential for growth that won't be federally taxed if account owners meet requirements for qualified distributions (state taxes may apply)
  • Brokerage accounts offer taxable growth potential
Here are some examples of how diversifying can benefit your investments
  • If you are eligible to take tax deductions in retirement, you'll need taxable income in order to take advantage of them. Withdrawals from a traditional IRA or 401(k) count as taxable income, so you could withdraw only enough to offset your eligible deductions and then draw the rest from your Roth account. Qualified distributions from Roth accounts are federally tax-free (and may be state-tax-free).

    If you have taxable accounts to draw from in retirement, you can draw them down and allow your traditional IRA and 401(k) assets to continue to potentially grow tax-deferred until your required beginning date after which time minimum distributions must be taken.
  • Effective January 1, 2020, in accordance with new legislation, the required beginning date for required minimum distributions (RMDs) is age 72. You may defer your first RMD until April 1 in the year after you turn age 72, but then you'd be required to take two distributions in that year. Failure to take all or part of an RMD results in a 50% additional tax applicable to the amount of the RMD not withdrawn. In addition, under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, all 2020 RMDs have been waived.
  • Money contributed to a traditional IRA or 401(k) on a tax-deductible or pre-tax basis is taxed upon withdrawal based on your future tax rate, which may be lower than your current rate. In contrast, money contributed to a Roth IRA or Roth 401(k) is taxed at current rates, and qualified distributions are federally tax-free and also may be exempt from state tax.
Spreading your contributions among different account types may help you reduce your taxes in retirement, whether your future tax rates will be higher or lower than they are now, if you take steps ahead of time to establish different account types for tax diversification.
Tax-efficient investing shouldn't supersede your existing investment strategy, but it is important to consider with your tax advisor when you're making investment decisions.

3. Choose tax-efficient investments

Specific investments can carry tax benefits, as well. For instance, income earned from municipal bonds is generally income tax-free at the federal level and, in some cases, at the state and local levels, too. Other tax-smart investments may include tax-managed mutual funds, whose managers work deliberately and actively for tax efficiency, as well as index funds and exchange-traded funds that passively track long-term investments in a target index. It's important to check with your tax advisor to make sure you understand the tax features of these investments.

4. Match investments with the right account type

It's important to make sure you're taking full advantage of tax-efficient investments by holding them in accounts with the appropriate tax treatment. Investing in this way can help ensure that you're realizing all potential tax benefits without increasing your tax liability.
  • Investments that regularly generate taxable income, such as taxable bonds or stock funds with high turnover, may be better held in tax-deferred accounts — traditional IRAs, for instance — to gain the best potential tax benefit.
  • Tax-neutral investments, such as tax-managed mutual funds and municipal bonds, are generally better suited for a non-tax-deferred account, like a taxable brokerage account. The reason? If your investments don't generate high taxes, there is less of a need to defer them, so there is little reason to put them in an account that could restrict your access to them.
Just be sure that the decisions you make about where to hold various investments are consistent with your overall financial strategy.

5. Hold investments longer to avoid unnecessary capital gains

It is rarely worth holding on to a stock you are ready to sell simply to avoid taxes — with one exception. While gains recognized on stocks held for a year or less are taxed at ordinary income rates, gains recognized on stocks held longer than a year are taxed at the long-term capital gains rate — currently 15% for most investors and 20% for high-income taxpayers. As a result, it may make sense to delay selling appreciated stocks until they qualify for long-term capital gains treatment. (There are currently legislative proposals under consideration to increase the top capital gains tax rate; you can read about them here.) Again, always check with your tax advisors.

6. Harvest losses to offset gains

Using any investment losses you may have to offset your investment gains each year — a technique called "tax loss harvesting" — can help reduce your income tax liability. And, if your investment losses exceed your gains, you can use them to offset up to $3,000 of taxable income each year as well, with additional losses carried forward to future tax years. For higher earning investors, a higher long-term capital gains tax rate plus a potential additional net investment income tax of 3.8% if the net investment income tax applies, can make "tax loss harvesting" even more valuable. But consult your tax advisor to ensure that the wash sale rules won't prevent you from using this strategy.
Whatever strategies you use, remember that tax-efficiency isn't the only consideration for your investment decisions. You also need to think about how each investment can help you pursue your diversification, liquidity and overall investment goals — at a level of risk you are comfortable with. Tax efficiency then becomes another way to help you choose among your investment options. Be sure to consult with your professional tax advisor before making decisions that will affect your taxes.
Next steps

Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa. Income from investing in municipal bonds is generally exempt from federal income tax and state taxes for residents of the issuing state. While the interest income is generally federal income tax exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the federal alternative minimum tax (AMT). The investments discussed have varying degrees of risk, and there is always the potential of losing money when you invest in securities. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad.

Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.