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How to Be a Tax-Smart Investor

Thoughtful decisions about the asset classes you choose and the accounts you hold them in could help you lower your tax bill

TAXES AREN’T JUST A ONCE-AND-DONE THING. There are plenty of steps, beyond the last-minute rush to file every April, that investors can take to help reduce their tax liability, says Mitchell Drossman, National Director of Wealth Planning Strategies for Bank of America’s Chief Investment Office. In fact, he adds, “It’s crucial to make tax considerations an integral part of every investment decision, all year round.”  

And you don’t have to go it alone. Your financial advisor can help you make critical decisions related to the timing of the purchase or sale of stocks, the asset classes you choose, whether you hold them in tax-deferred or taxable accounts, and the order in which you draw down your assets—all of which could potentially help to lower your tax bill and increase your overall return on investment.

Asking your advisor the following five questions could help you minimize the tax impact on your returns.

What asset classes should I consider owning?

Before you decide on the percent of stocks, bonds and cash instruments that make the most sense for you, it’s helpful to understand how the IRS treats the income from those asset classes. Regular income, including from interest payments on bonds and cash, is taxed at individual rates as high as 37%. Profits from the sale of stocks you’ve held for more than a year qualify as long-term capital gains, and the long-term capital gains tax rate maxes out at 20%. But be aware that if you hold a stock a year or less and sell it at a profit, the gain will be taxed at your individual rate, which could be considerably more than 20%.

Image is a fact card. Hed text reads: Want to be a tax-smart investor? Consider these 5 tips. From top to bottom, there is a list with icons on the left and tips on the right. The first icon is of a funnel, and beside it is the text: Concentrate assets that generate income in tax-deferred retirement plans. Second is an icon of a pie chart, and beside it is the text: Hold non-income-producing assets, such as growth stocks, in taxable accounts. Third is an icon of a caution symbol, and the text next to it reads: Try to avoid selling stocks you’ve held for less than a year. Fourth is an icon of a clock with the text next to it saying: Leave as much as you can in your retirement account as long as you can. The fifth tip has an icon of a calculator, and the accompanying text is: Don’t buy or sell assets just to avoid taxes—it could be counterproductive. At the bottom of the card is the disclaimer: Merrill does not provide tax advice.

 

Should I invest them in a tax-deferred or taxable account?

 “Your advisor can help you think through the tax implications of where you hold different types of investments,” says Drossman. For instance, currently investment income from assets held within a traditional 401(k) or IRA generally isn’t subject to taxes until you withdraw it. For that reason, you may want to place holdings that generate ordinary income—bonds or non-qualified dividend-producing stocks—in tax-deferred retirement plan accounts. (Withdrawals you take during retirement will be taxed at your personal income rate, which may be lower at that time.)

By contrast, it’s often smart to hold non-income-producing assets, such as growth stocks, in taxable accounts. Even if they increase substantially in value, you won’t experience any tax consequences until you sell them.

Another exception: municipal bonds, which are generally exempt from federal (and, in some cases, state and local) taxes, notes Drossman. Ask your advisor whether muni bonds, which often have a lower yield than other bond options, may be a better choice for your taxable portfolio. 

“It’s crucial to make tax considerations an integral part of every investment decision, all year round.”— Mitchell Drossman, National Director of Wealth Planning Strategies for Bank of America’s Chief Investment Office

When should I begin taking withdrawals in retirement?

“Leave as much as you can in your retirement accounts as long as you can, so those investments can continue to grow on a tax-deferred basis,” says Joe Curtin, head of CIO Portfolio Management for the Chief Investment Office of Merrill and Bank of America Private Bank. As long as you’re working, you generally don’t need to take required minimum distributions (RMDs) from your qualified retirement plan, such as a 401(k), and thanks to the SECURE Act, you won’t be required to begin taking RMDs from your IRA until age 72 (for those who turn 70½ on or after January 1, 2020).1

If you need additional money beyond RMDs to meet living expenses, your advisor can help you review other possible sources, such as cash or assets in taxable accounts, that may be preferable to tap to avoid depleting your retirement accounts. “Then, you can make any necessary adjustments to your portfolio, keeping the tax implications in mind,” says Curtin.

How can I make tax-efficient donations?

The 2017 tax law may have curtailed your ability to deduct charitable donations from your taxes. However, by donating appreciated shares of stock directly to charity, you can avoid the capital gains taxes that would apply if you sold the stock first and then donated the proceeds. Your tax advisor can help you consider whether donating appreciated stock makes sense for you.

If you’re retired, and don’t need all of your RMDs for living expenses, you could donate assets directly from your traditional IRA to an eligible charity in the form of a Qualified Charitable Distribution (QCD). You can make QCDs of up to $100,000 annually, says Drossman. Your tax advisor can help you consider whether making a QCD could help you lower your taxable income.

What tax implications do I need to consider before buying and selling assets?  

“Leave as much as you can in your retirement accounts as long as you can, so those investments can continue to grow on a tax-deferred basis.” — Joe Curtin, Head of CIO Portfolio Management for the Chief Investment Office of Merrill and Bank of America Private Bank.

In a good year, you may want to lock in gains by strategically selling appreciated assets. “But try to avoid selling stocks you’ve held a year or less, since they’ll be taxed at your individual rate for ordinary income, while you’ll pay no more than a 20% tax on long-term investments,” says Drossman.

When you sell, you may be able to take advantage of tax-loss harvesting, or selling investments that have dropped in value in order to offset taxable gains. You can generally deduct up to $3,000 (or $1,500 if married and filing separately) of capital losses in excess of capital gains per year from your ordinary income. And if your net capital losses exceed that yearly limit, you can carry over the unused losses to the following year. Your advisor can look for opportunities to do this throughout the year.

“If you wait until the end of the year, you’re almost entirely dependent on what happens in the markets during the month of December,” says Curtin. Keep in mind that if you buy substantially identical stocks within 30 days before or after the sale, it will be considered a “wash sale,” and you may not be allowed to subtract those losses from your gains for that taxable year.

While taxes should be factored into your investment decisions, buying or selling assets solely to avoid taxes could be counterproductive, Curtin warns. For example, given the recent strong market conditions, you might look at capital gains tax as a necessary cost in order to capture substantial gains, he says. By contrast, investors who hold on to those assets for fear of taxes could lose out if markets change and those assets drop in value.

All the more reason to work with your advisor to think through every consideration about your life and financial goals—not just the tax implications—as you make your investment decisions throughout the year.  

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Individuals generally must begin taking RMDs from their qualified retirement plans on the later of the calendar year in which they reach the required age (72 or 70 ½, as applicable) or retire.

Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice.  You should consult your legal and/or tax advisors before making any financial decisions.

The Chief Investment Office, which provides investment strategies, due diligence, portfolio construction guidance and wealth management solutions for Global Wealth & Investment Management ("GWIM") clients, is part of the Investment Solutions Group (“ISG”) of GWIM, a division of Bank of America Corporation (“BofA Corp.”)

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