Investing is not easy. You may fail to get the results you expect if you pick the wrong stock, take on too much risk, over-trade, or fail due to many other factors. Even then, if you follow a passive strategy to track the market, you results could be derailed by shifting strategy at the wrong time due to fear or greed, or by excessive fees. Shelves have been filled with books on advice for being a better investor. Television channels are devoted to investment news. It’s pretty clear that beating the market consistently is not easy.
However, like the drunk looking for his keys, who decides to look under a streetlight rather than where he actually lost them (because that’s where the light is best), investors spending time on developing and monitoring complex investment strategies may be missing an opportunity to simply be smarter about their taxes. Investors are constantly looking for ways to achieve a better return, but being smarter about taxes may be an opportunity to help returns that is hiding in plain sight and I would argue that compared to beating the stock market, it’s far easier and more reliable.
Before I start on the details, the goal of this article is not to discuss complicated offshore tax havens, highly paid tax lawyers and accountants or other potentially questionable and expensive tax practises. The goal is to use tax rules that have been set up to help and promote long-term saving. So the topics here involve working with the tax code, rather than finding more obscure loopholes.
Holding On For Long Term Gains
One of the easiest tax benefits to take advantage of is to hold investments for more than 1 year. Typically investments such as stocks and bonds are taxed at the same rate as your income if held for a year or less.
However, if you hold many investments for over a year they are taxed at the long-term capital gains rate. This can make a big difference: if you earn 10% on an investment and pay tax at 35%, then your post-tax return is 6.5%., But, if what you earn qualifies as a long-term gain, then your post-tax return is 8.5% — that’s a material difference, most tax brackets pay a 15% rate of capital of gains tax. Even better, if you’re in the 10% or 15% income tax bracket your long term capital gains rate can be 0%. If you’re paying the top rate of tax, your long-term capital gains tax rate is generally 20%.
Of course, much depends on your investment strategy, but if you have stocks or bonds that you expect you can hold for over a year with similar return prospects, then it may make sense to do so. Note that other assets including coins, art, collectibles and small business stock typically receive different tax treatment and all tax rates are based on the 2015 rates and code, which could change. Waiting for a long-term gain may require a little more patience, but it can be a simple way to improve the returns you receive. Of course, this only helps with gains; if you’ve lost money, there isn’t necessarily a tax benefit to holding the investment. In fact, using a strategy of tax loss harvesting can be helpful.
If you are saving for a particular purpose, there may well be a tax-efficient way to do it. Saving for retirement is the most obvious category – 401(k) plans, 457 plans, 403(b) and the TSP are all set up to help you save for retirement.
Typically you don’t avoid taxes entirely with these plans, but instead defer them, potentially over decades, which can be a big help. Often when you contribute money to a pension the funds can be contributed pre-tax and grow tax-free.
How much does this matter? Well, assume you pay tax at 30% and have an investment that pays 5% interest a year. After 20 years you’d have over $26,000 if saving via a pension, and just under $14,000 if saving in a taxable account. That’s a big difference.
Now, there is a slight catch in that typically tax must be paid on withdrawals in retirement — but at that time many Americans are in a lower tax bracket. Furthermore, in the example above, even if the investor paid 30% tax at the end of the period, they’d end up with over $18,000 or a third more than the investor that didn’t save through a tax-efficient plan – this is due to the benefits of tax-free compounding.
These investments only work if you are saving for the intended goal; if you use the money for something other than retirement, there are typically penalties as well as taxes, and of course the details and US tax rates could change.
Nonetheless, today, if you’re saving for retirement, using a tax-efficient retirement account could improve your outcomes because of the tax efficiency. Depending on your income level, a Traditional IRA may offer a similar benefit, but higher income Americans may not qualify to make initial contributions tax-free which reduces some of the attraction.