Cutting Taxes Is the Easiest Way to Boost Investment Returns

Most investors overlook the best ways to increase net investment returns. These methods don’t depend on market performance and are more reliable than new investment techniques. The easiest way to raise investment returns is to reduce income taxes on your income and capital gains.

In other words, increase your after-tax rate of return by reducing taxes. Many investors focus on whittling down investment expenses. But taxes on their investment income and gains are the biggest expense most investors incur. Often, one good tax reduction strategy puts more money in your account than lowering other investment expenses. Too many investors think of investment tax planning as year-end tax planning.

They wait until late in the year to consider a few moves to make. That leaves a lot of money on the table. Investment tax planning can be lucrative when done all year. It’s not quite a free lunch, because it does involve some work. But good investment tax planning can pay off handsomely. Tax loss harvesting is a key investment tax strategy and the one most used. It often is the essence of year-end tax planning for investors. The strategy is simple. When an investment in a taxable account has a market value that’s less than its purchase price, consider selling the asset.

The capital loss offsets any capital gains you recognized for the year. Plus, up to $3,000 of capital losses that exceed gains for the year can be deducted against other types of income. Any additional excess capital losses can be carried forward to future years. You can sell and use the loss even when you still like the investment if you avoid the “wash sale” rules. You can buy the asset back after more than 30 days pass, or you can buy a comparable asset that’s not substantially similar.

More details about the wash sale rules are in the March 2023 issue of Retirement Watch. Many people don’t consider tax loss harvesting until near the end of the year. It is best to consider it throughout the year. When the markets take a dive or one of your investments tumbles and generates a paper loss, consider whether a strategic tax sale is in order. Tax loss harvesting isn’t the only strategy to consider. When you’re raising cash to spend or reposition your portfolio, carefully consider which assets to sell. Ask two questions.

How long have you owned the investment? Ideally, in a taxable account you don’t sell an investment at a gain unless you’ve held it for more than one year. That gives you a tax advantaged longterm capital gain with a maximum rate of 20%, instead of a short-term capital gain that’s taxed as ordinary income. How much is the gain? When you’re selling investments to generate cash, it’s best to sell assets with the lowest gains as a percentage of the sale price. The lower the gain is as a percentage of the sale price, the more of the gain you’ll be able to spend after paying taxes.

That also means you’ll have to sell less of the investment to generate the after-tax spending cash you’re seeking. Of course, it’s best not to sell assets that have substantial capital gains unless there are capital losses to offset at least part of the gains. Also, if you hold highly appreciated assets for life, then your estate or heirs will increase the tax basis to the current fair market value. No one will have to pay capital gains taxes on the appreciation that occurred during your holding period. Another strategy is to optimize taxes for the year by considering all the types of accounts you own before deciding on the source of a distribution.

Many people follow the old guidelines of drawing from taxable accounts first, tax-deferred accounts next, and tax-free accounts last. There are good reasons for those guidelines, but they don’t result in maximum after-tax cash flow for many people. To optimize taxes, consider your entire tax picture for the year. Estimate the amount of income you’re likely to have from all sources and where that income places you in the tax bracket.

Also, consider more than your income tax bracket. Consider your potential liability for the Stealth Taxes, such as the Medicare premium surtax, tax on Social Security benefits, and others. See our May 2023 issue and Chapter 10 of my book, “Retirement Watch: The Essential Guide for Retiring in the 2020s,” for details about the Stealth Taxes. If more taxable income might push you into the next higher tax bracket or increase Stealth Taxes, it’s probably not ideal to realize capital gains in a taxable account or take distributions from an ordinary IRA or 401(k).

Instead, take the extra cash you need from a taxfree account, such as a Roth IRA or a health savings account. In a year, when your other income sources are low or you have a higher-than-usual amount of deductions, consider taking the extra money you need from a traditional IRA or 401(k). Of course, the investment fundamentals always come before tax considerations. But once you’ve decided to buy or sell investments, consider the tax implications before choosing the timing.