If you have a taxable account (IRAs and 401(k)s are not taxable accounts), then you must report investment income on your tax return.
3 Forms of Investment Income
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Dividends and Interest. Stocks pay dividends, which are usually taxed at favorable “qualified dividend” rates. Bonds produce non-qualified interest income, which is taxed at higher ordinary income rates.
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Realized Gains/Losses. When you sell an investment, you report whether you sold it for a gain or a loss. At the end of the year, you pay capital gains taxes on any net total gain.
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Capital Gain Distributions. The mutual funds you own realize gains on investments they sell. Tax law requires that funds pass those gains to shareholders annually.
Funds generally issue capital gain distributions in December. On distribution day, shareholders receive cash from the fund and the fund’s value correspondingly drops. The investor must report the cash as a capital gain. Often, the cash is automatically reinvested in the funds.
While pesky, capital gain distributions do not increase your expected lifetime tax obligation. They just accelerate it. The distributions increase cost basis in the fund thereby reducing future taxes when you sell the investment.
Tax Efficient Management of Your Portfolio
One of the principal ways we add value is through tax efficient management of your portfolio. Here are a few of our tactics to reduce your taxes:
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Asset location. When we manage a client portfolio that includes taxable and non-taxable accounts, we prioritize tax efficient assets in the taxable accounts and push tax inefficient assets to the non-taxable accounts. A major factor in evaluating an investment’s tax efficiency is the potential capital gain distributions.
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Municipal bonds. We may replace taxable bonds with tax-free municipal bonds in taxable accounts.
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Tax loss harvesting. We look for positions in your portfolio that have an unrealized loss i.e. the value is lower than the cost basis. We consider selling those positions to generate a capital loss that you can use to offset capital gains.
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Trade efficiency. We construct portfolios to trade infrequently in large part to limit taxable gains. When we do sell, we look at investment lots (the units that make up an investment) and sell those that minimize the tax impact.
We have a saying: “don’t let the tax tail wag the dog.” In other words, our central goal is to build a portfolio that is likely to achieve your goals. Tax efficiency contributes to that objective but it is not the overriding concern.
We are always happy to discuss tax management for your portfolio. Please reach out to your adviser for further discussion.
