“I’m proud to be paying taxes in the United States. The only thing is — I could be just as proud for half the money” -Arthur Godfrey
Tax evasion — the act of deliberately misrepresenting your income, overstating deductions, hiding money and investment gains offshore, and in general lying to the tax authorities — is illegal. So, you know… you shouldn’t do it. Tax avoidance, however, is perfectly fine. Tax avoidance means that you work within the tax laws tolegally reduce your tax burden, and there are a number of ways to do this when it comes to investing.
Before I go any further it is incumbent upon me to disclose that I am not a Certified Public Accountant (CPA), and as such I am not qualified to give tax advice. I will only try to give you an investment manager’s perspective on the topic. You should always consult a tax accountant regarding any questions related to taxes.
Now assuming you have no desire to renounce your citizenship, as a record number of 3,415 former Americans did in 2014, the idea of moving yourself or your investments to some tropical tax-haven is probably off the table. That’s because if you are a U.S. citizen — or a citizen of that other economic behemoth, Eritrea — your investment gains and income are still subject to taxes back home even if you don’t live there anymore and you earned it in a different country altogether. Still, there are a number of other ways to reduce your investment-tax burden legally.
1. Tax-Advantaged Bonds
A favorite of wealthy old ladies, municipal bonds are issued by state, county, city, and other local governments and their agencies to fund construction projects. They are used to build schools, hospitals, and infrastructure such as bridges, roads, and sewage treatment facilities. They are also used for less noble projects, like building a stadium where people can go watch the Jacksonville Jaguars play. If they wanted to. Which they don’t. In most states munis are tax-exempt at the federal, state, and local levels, making them particularly attractive for the taxable accounts of higher-earning individuals.
2. IRAs, 401(k)s, and Tax Diversification
I talked in more detail about the benefits of tax-advantaged retirement accounts in my last blog post. In and of themselves they are a great way to defer taxes on investments or avoid them altogether. In addition to that, if you fund both an after-tax Roth and the traditional pre-tax type accounts you will provide yourself with tax diversification. Having savings in both types of accounts affords you much more flexibility in managing your tax liability in retirement.
For example, let’s say you need to take out $65,000 per year from your retirement accounts to support your early-bird addiction at Golden Corral. If you have to fund those expenses from only a traditional account you will be pushing yourself past the 15% bracket and into the higher 25% bracket ($36,900 to $89,350 based on 2014 tax rates, “single” filing status, $6,200 standard deduction, and $3,950 personal exemption). On the other hand, if you have both types of accounts you could take the first $50,050 out of your traditional type — moving you right up to the 25% bracket line, but not crossing it — then pull the other $14,950 tax-free out of your Roth.
3. Minimize Portfolio Turnover
When you buy an investment and the value increases above your cost of purchase, this is called a capital gain. This is known as an unrealized capital gain until the time it is sold, when it becomes a realized gain and is subject to taxes. So as long as you don’t sell an investment, you don’t have to pay taxes on the gains.
There are certainly times when you should sell an investment — like when the long-term prospects for it have soured or you need to rebalance your account — but trading absent need or sound rationale should be avoided. Frequent trading is likely to generate short-term capital gains. These are gains that are realized on investments held less than one year, and they are taxed at the investor’s marginal income tax rate, not the more favorable capital gains tax rate that applies to long-term capital gains (those from investments held more than one year).
4. Tax-Loss Harvesting
If you do have some realized capital gains in your portfolio you should look for unrealized losses in your portfolio which can be realized to off-set those gains. The IRS also currently lets you deduct up to $3,000 in realized losses every year, and any realized losses in excess of this carryover into subsequent tax years until they are used.
Keep in mind there is a 31-day wash sale rule, though — if you want to buy the security back you have to wait 31 days or you will forfeit the realized capital loss. To avoid missing out on market movements during this time, you should consider swapping the position into an ETF or other vehicle that gives you somewhat similar exposure.
5. Invest in ETFs
Due to the structure of most ETFs and how they are created and redeemed by market makers, they typically don’t distribute much — if anything — in the way of capital gains to their shareholders. This makes them an excellent choice for investors who want to be tax-efficient. Actively managed mutual funds, however, often have net realized capital gains that need to be distributed to shareholders each year. This is typically done in late November or December, and there is nothing an investor in the fund can do to avoid it aside from selling the fund before the gain is distributed (which can often result in a realized gain anyway).
6. Die
Kicking the bucket is also a very effective tax strategy. When you die the cost-basis of your investments is reset to the market price on your date of death, thus eliminating any taxable capital gains they may have had. Sure, it’s a bit extreme and final. But it works.
