Are you sick of taxes yet?
Photo: Steve Buissinne. Source: Pixabay
I certainly am. I’ve been gathering reports for months, updating my tax software, executing an initial draft, doing another system update, trying again. The only good thing about this tax season has been the extended deadlines. Of course, not in New Hampshire! Since we don’t have an “income tax” (koff!), they didn’t feel the need to extend the deadline. Never mind that the New Hampshire forms depend on the information we got from delayed (& corrected) forms filed by banks and brokers. Never mind that most states *did* extend their deadlines. Oh well. I wasn’t planning to do anything that weekend, anyway.
Much as we dislike them, taxes are one of the most important things to consider when we structure our investments. Whether we like it or not, the government is our partner in our financial dealings. Money, banking, and investing need to take this into account or they’re not considering the world as it is. This can be challenging because everyone’s taxes are different. But the reality of tax considerations is especially visible to us in April, with all the Certified Mail packages being delivered.
And we don’t need to be tax attorneys or a CPA to understand that capital gains, wash sales, qualified dividends, and State and local taxes make a big difference to our wealth. A recent story in Forbes describes the plight of an active Robinhood trader who didn’t understand about wash sales. He had turned $30,000 account into $75,000 through active trading. But the trading was *really* active. He would trade 10 to 50 times a day and racked up $45 million in trades with $1.4 million in capital gains. Because of wash sale rules, his losses were disallowed. Turbo tax told him that he owed $800,000 in taxes. I’d guess Robinhood won’t be sending up rockets on his app.
Tax-aware investing doesn’t have to be complicated, but it does need to consider where you put your assets. For example, if you have money in a Roth IRA and a taxable account, you can share your losses with your partner, the Government, in the taxable account – through tax-loss harvesting or other tax-management techniques.. But gains and losses in the Roth are totally on you. That’s why it makes sense to have less risky investments in the Roth – especially as you approach retirement.
There are also a number of notoriously tax-inefficient investment vehicles. These securities and funds create tax liabilities but they don’t give you the cash to pay your taxes. Mutual funds with large capital gains distributions are one example. Inflation-protected bonds are another. With an inflation-protected bond, the principal growth with the CPI – as does the coupon payment. That principal increase is a taxable event. But you can’t spend the bond’s principal – at least, not until the bond matures. But you would owe taxes NOW on the bond’s appreciation. The same is true of long-term zero-coupon bonds.
Tax-inefficient investments should be in an IRA, where they can do their thing without the Government taking a slice. They’re not so hot elsewhere.
Taking aim at taxes? Photo: Tim Pollard. Source: Wikipedia. CC BY-SA 4.0.
There are other ways to manage your tax liability. Suppose you have a taxable portfolio that’s doubled, but you’re concerned about the market. You *could* sell out, but that would cost a lot in taxes. Or you could hedge. Suppose the market goes down 20%. You’ll have a gain on your hedge, which you can realize, taking *that* gain. Your portfolio has been protected, and your taxes are a lot lower.
I’ve never understood why people obsess about management fees but just give up when thinking about taxes. This isn’t rocket science. To be tax-efficient we just need to keep our partner in mind. Because investing isn’t about what we make. It’s about what we keep.