Community Involvement


It’s Not About What Your Earn, It’s About What You Keep: 3 Strategies to Minimize Taxes on Your Investment Portfolio

By Derek S. Peterson, CFP®, CRPS® Wealth Management Advisor

If you’re confused about your tax strategy, it’s not your fault. According to eFile, the tax code could be printed on a single page in 1913. Today, it would take up to 174 pages. That’s a lot of rules and regulations for the average person to keep track of.

Because the tax code is so complex, most people don’t consider their tax bill when selecting investments. Fortunately, a few simple strategies can help maximize your return and minimize your tax liability, helping you keep more of what you earn.

Tax-aware investing results in a long-term approach to building wealth, perfect for those who plan to use their after-tax monies to fund retirement. It’s not about tax avoidance but rather higher after-tax wealth.

Taxes are a drag

We all know how taxes can affect your income, but taxes can also seriously erode your investment returns. This is called “tax drag”—your pre-tax return minus your after-tax return. Reducing this drag by even a percentage point can make a huge difference over time.

Simple strategies for your portfolio

You can start by considering some simple changes to your portfolio that are designed to limit lost earnings from your investments.

  1. Defer gains. Since you don’t pay taxes until you realize gains, deferring taxes into the future can significantly compound returns over time. Russell Investments provides the following example in “Three Reasons to Consider Tax-Managed and Tax-Exempt Funds” to illustrate the point: By deferring all your gains on a hypothetical investment of $1 million, you would end up with $518,000 more after 10 years, assuming an 7.5% annual rate of return. 
  2. Calculate your tax-equivalent yield - your rate of return after taxes, not before. A higher return doesn’t always mean more money in your pocket, since those investments might pay interest, dividends or capital gains. Because you often pay taxes from a different account, such as your checking or savings, it’s easy to ignore the impact of taxes on your investments. Make sure you connect each investment with its tax bill to track your true rate of return.
  3. Principles
  • Harvest losses
  • Reduce turnover
  • Pay attention to the holding period
  • Defer realized gains and select tax lots

Still confused? This chart shows the varying tax rates for different types of investments. 

Top Tax Rate

Investments

40.8%

  • Non-qualified dividend income
  • Short term capital gains
  • Interest income

23.8%

  • Qualified dividends
  • Long-term capital gains

0%

  • Municipal bond interest
  • Unrealized capital appreciation
 

The tax rates indicated in the chart above are for the current (as of 3/2021) federal rates for the top tax bracket.

Keeping what you earn

Tax season is a great time to reconsider your investment strategy. Once you calculate your true after-tax rate of return for your investments, you may recognize a need for tax-aware investing.

Implementing the strategies above could potentially save you thousands or tens of thousands of dollars on your returns over time. Professional guidance from an understanding advisor can help you craft an investment strategy designed to maximize your rate of return and while minimizing your tax liability.

Recently, a client who had newly inherited money from her mother called to get a perspective on the portfolio. I ran an analysis on the existing holdings and determined that she would likely have to recognize a lot of taxes at the end of each year. Using visuals to guide the discussion, I demonstrated how to reduce her tax liability by changing the allocations from more tax-efficient investments without having to sacrifice return or taking on more risk.

As the saying goes, it’s not about what you earn, it’s about what you keep.

*This article is not intended as legal or tax advice.  Financial Representatives do not render tax advice.  Consult with a tax professional for tax advice that is specific to your situation. 


 

Derek S Peterson, CFP®, CRPS®

Wealth Management Advisor

 

To learn more about Northwestern Mutual Investment Services, LLC and its financial representatives, visit: FINRA BrokerCheck