Manage The Tax Bite on Your Investments - Schwab market snapshot 023

Well, it’s almost April, and that means tax season is just around the corner. So, today, I’m speaking with Rande Spiegelman, Schwab’s vice president of financial planning. He’s a CFP and CPA, and he’s Schwab’s resident tax expert. So, Rande, welcome. Thank you. So, Rande, I think just about everyone thinks about April as tax season, but when it comes to investing, taxes are one of those things that we have to think about all year long. And as an investor, taxes can take a big bite out of profits and your success as an investor. So what can we do as investors to make sure that we’re maximizing our tax efficiency? That’s right, Randy. We worry about stretching for every last basis point of return in the market, but two of the biggest things we can do is to keep costs low and engage in some proactive tax planning. Now, of course, that includes maxing out on tax-advantaged retirement accounts when possible, like your 401(k)s at work and your individual retirements accounts, either traditional or Roth; that depends on your circumstances. And, if you expect to be in a higher bracket when you withdraw the money, a Roth typically is going to make sense. Otherwise, if you expect you’re going to be in a lower bracket when you take out the money, a traditional deductible IRA is going to win out. Now, on top of that you want to be thinking about proactively harvesting losses in taxable accounts to offset gains throughout the year. The main things to keep in mind here are that you need to watch out for the wash-sale rule, and you don’t really necessarily need to wait until year-end. Again, this could be a year-round exercise. We’ve written a lot about loss harvesting and the wash-sale rule on Schwab.com, so be sure to check out the articles there. That’s great. So, you know, we tend to talk about diversification among asset classes as a way to reduce risk, but there’s also a different type of diversification that we call tax diversification. So can you walk us through exactly what we need to do to make sure that we’ve got our investments in the right places so that we’re being tax-efficient in how we invest? Sure. As I mentioned, of course, you want to be taking full advantage of those tax-preferenced accounts, and, beyond that, once those are established, there are a couple of additional things that you can do. First, you should be looking at implementing your overall asset allocation efficiently between account types, and that typically means putting tax-inefficient assets that tend to generate ordinary income in your tax-advantaged retirement accounts. And then use your taxable accounts for investments that generate preferential income, like long-term capital gains, qualified dividends and tax-exempt interest. Also, unless you’re absolutely sure about your future tax bracket and whether a traditional deductible IRA or a Roth IRA makes sense, you can hedge yourself by splitting your annual contribution limit between both types of accounts. And most of us don’t know for sure what bracket we’re going to be in, so you put a little bit in both, maybe split the difference. The same goes for traditional versus Roth 401(k)s. That way, for retirement, you’ll have your regular taxable brokerage account, where you can take advantage of long-term capital gains, qualified dividends and tax-free muni bonds, as I mentioned, you’ll have a traditional IRA that gets taxed at the ordinary rate when you withdraw the money, and a tax-free Roth account. Now, diversifying across these account types will give you more flexibility in structuring your retirement cash flow in the most tax-efficient way, and this will allow you to better manage your tax bracket in any given year. Well, now, two areas that investors sometimes don’t spend enough time thinking about are estate planning and charitable giving. And there are ways that we can be more tax-efficient in those areas, as well. So can you talk a little bit about that? Sure. You know, typically, you want to give low-basis assets that you’ve held for the long term to qualified charities. That way you will be eligible for a full fair market value deduction without having to pay any capital gains tax. And the same goes for your estate. Your heirs will get a step up in basis equal to the fair market value at your date of death and long-term treatment regardless of the holding period. Of course, as always, you have to coordinate any gift or estate plan with your overall portfolio plan and your investment goals. I mean, the investment decision should always come first when you’re considering tax and estate matters. Well, now, Rande, I spend most of my time talking to active traders, and active traders sometimes struggle with whether or not it makes sense to trade in a tax-advantaged account or a regular taxable account. So can you talk a little bit about how to make that decision? Sure. It’s true you won’t have to worry about short-term capital gains when you’re trading successfully in a tax-advantaged account. Now, on the flipside you can’t deduct any losses against current taxes. So what else do we as investors, or even as traders, need to know that we really haven’t talked about yet today? Well, we think it’s a really good idea that as you periodically rebalance your portfolio to get your asset allocation in line that you should first use your tax-advantaged accounts, if you can, to sell appreciated assets. Now, you can always add new money to undervalued asset classes in either type of account as you rebalance. But if you’re still saving for retirement, triggering capital gains by selling appreciated assets in your taxable account should really be the last step, and only as needed to keep your portfolio in balance. Retirees can effectively combine their cash flow needs with a periodic rebalancing exercise as they take distributions from their retirement accounts. And, finally, speaking of asset allocation and cash flow, a preference for liquidity might prompt you to hold bonds in your taxable account, even if it makes more sense from a tax perspective to hold them in a tax-advantaged account. If you do end up holding bonds in your taxable accounts, you should compare the after-tax return on those taxable bonds to the tax-exempt return on municipal bonds to see which makes the most sense on an after-tax basis. After all, it’s really not what you earn that counts in the end. It’s what you get to keep after taxes. I think that’s a very valuable point and a very good thing for people to keep in mind. Rande, unfortunately, we’re about out of time. So thank you so much for making this this complicated subject a little bit easier to understand. If you want to read more from Rande about taxes and estate planning and that sort of thing, you can read it on Schwab.com in the Market Insight section. And of course you can always follow me on Twitter @RandyAFrederick. So until next time, invest wisely. Own your tomorrow.