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.

Key points

  • Contribute as much as possible to all tax-efficient accounts, such as IRAs and 401(k)s, to help provide the opportunity to build wealth while minimizing taxes
  • Diversify your investment account types to potentially help reduce taxes in retirement
  • Consider managing the tax impact of investment gains by minimizing turnover, harvesting losses and choosing tax-efficient investments
Meaningful tax planning has been challenging in recent years, as Congress has favored short-term fixes for long-term tax problems.
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 marginal federal income tax rate, the more you may want to consider the impact of taxes when making changes to your investments, but be sure to consult with your professional tax advisor before making decisions that will affect your taxes.
Keep the following six strategies in mind:

1. Contribute to tax-efficient accounts

Take advantage of tax-efficient retirement accounts for which you are eligible to reduce current and or future taxes.
Current income tax impact:
  • Traditional IRA contributions are 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 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 with pre-tax contributions reducing your current taxable income, and are subject to annual contribution limits
Future income tax impact:
  • Traditional IRAs and 401(k)s offer tax-deferred growth potential
  • Roth 401(k)s and Roth IRAs offer tax-free growth potential
(See the chart below for limits on what you can contribute and income limits.)
Contribution limits
  2018 2017
Traditional* and Roth IRA**
Contribution limit
if you are up to age 50 and will not turn 50 during the year
$5,500 $5,500
Catch-up contribution limit
if you are age 50 or older***
$1,000 $1,000
Total contribution limit
if you are age 50 or older***
$6,500 $6,500
Contribution deadline**** 4/15/19 4/17/18
401(k)
Contribution limit
if you are up to age 50 and will not turn 50 during the year
$18,500 $18,000
Catch-up contribution limit
if you are age 50 or older***
$6,000 $6,000
Total contribution limit
if you are age 50 or older***
$24,500 $24,000
Contribution deadline 12/31/18 12/31/17
* Contributions to Traditional IRA accounts may be tax deductible. If you participate in an employer-sponsored retirement plan, the tax laws limit the deductibility of your contributions based on modified adjusted gross income (MAGI) ranges that are published annually and correspond to your federal tax filing status — if your MAGI is less than the lower limit, you are eligible for a full deduction for your contributions; if your MAGI is between the limits, you are eligible for a partial deduction; and if your MAGI is above the upper limit you are not eligible for a deduction. The Traditional IRA MAGI ranges are: $63,000-$73,000 in 2018 and $62,000-$72,000 in 2017 (single and head of household); and $101,000-$121,000 in 2018 and $99,000-$119,000 in 2017 (married filing jointly and qualified widow(er)). If you do not participate in an employer-sponsored retirement plan but your spouse does and your filing status is married filing jointly, the deductibility of your contributions is determined based on the MAGI range of $189,000 - $199,000 in 2018 and $186,000-$196,000 in 2017.
Generally, if you are married filing separately, you are not entitled to a deduction for contributions to a Traditional IRA if your MAGI is $10,000 or more and you or your spouse participate in an employer-sponsored retirement plan. However, if you are married and file separately but do not live with your spouse at any time during the year, your maximum deduction is determined as if you were a single filer.
If neither you nor your spouse is covered by an employer retirement plan, the maximum deduction is either $5,500 or $6,500, depending on whether you are age 50 or older at any time during the year to which the contributions relate.
** Whether you are eligible to contribute to a Roth IRA is based on your MAGI. The tax laws limit the eligibility to contribute to a Roth IRA based on MAGI ranges that are published annually and correspond to your federal tax filing status — if your MAGI is less than the lower limit, you are eligible to contribute up to the annual contribution limit for the year; if your MAGI is between the limits, you are eligible to make a partial Roth IRA contribution; and if your MAGI is above the upper limit you are not eligible to contribute to a Roth IRA. The Roth IRA MAGI ranges are: $120,000-$135,000 in 2018 and $118,000-$133,000 in 2017 (single and head of household); and $189,000-$199,000 in 2018 and $186,000-$196,000 in 2017 (married filing jointly and qualified widow(er)).
Generally, if you are married filing separately, you are not entitled to contribute to a Roth IRA if your MAGI is $10,000 or more. However, if you are married and file separately but do not live with your spouse at any time during the year, your maximum deduction is determined as if you were a single filer.
*** You are treated as being age 50 or older if you will turn age 50 or older at any point during the calendar year to which the contributions relate.
**** You generally have until April 15th of each year to make IRA contributions for the previous year to which the contributions relate. If April 15th falls on a weekend or a holiday, the deadline is typically the next business day.

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, including:
  • Traditional IRAs offer tax-deferred growth potential
  • Roth IRAs 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 this can be a benefit:
  • 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 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 assets to continue to potentially grow tax-deferred until age 70½, after which time minimum distributions must be taken.
  • Money contributed to a Traditional IRA will be taxed upon withdrawal based on your future tax rate, which may be lower than your current rates. In contrast, money contributed to a Roth IRA is taxed at current rates, and qualified distributions are federally tax-free and may also be exempt from state tax.
Splitting contributions among different account types may help you hedge on whether your tax rates in the future will be higher or lower than they are now. This type of planning is possible only if you take steps now 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 tax-free at the federal level and, in some cases, at the state and local levels too. Other tax-smart investments 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 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 no 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. Whereas 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 the highest earners. As a result, it may make sense to delay selling appreciated stocks until they qualify for long-term capital gains treatment. 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 earned 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 the additional net investment income tax of 3.8% that became effective in 2013 can make "tax loss harvesting" even more valuable.
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.

Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

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