When you invest, your main focus should be achieving your financial goals, not avoiding taxes. That said, if an investment decision causes your tax bill to go up, it will take you longer to achieve your goal. So what should you do? Be aware of the impact taxes can have.
CAPITAL GAINS REFRESHER COURSE
For most taxpayers, long-term capital gains and qualified dividends are generally taxed at 15%. Those in the 39.6% ordinary tax bracket pay 20% (the highest rate). For taxpayers in the 10% or 15% bracket, the rate is 0%. Short-term gains* and interest are taxed as ordinary income. Note that high-income investors may be subject to an additional 3.8% net investment income tax.
From a tax standpoint, it may make sense to hold investments that are taxed at relatively low rates, such as stocks you intend to hold for more than one year, in a taxable investment portfolio. That way, taxes wouldn’t be due until you sell shares and realize a capital gain.
THE TAX DEFERRAL ADVANTAGE
Alternatively, you might consider holding investments that generate ordinary income (e.g., bonds that pay taxable interest) in tax-deferred accounts, such as a 401(k) or individual retirement account (IRA). You’d avoid having to pay income tax until funds are withdrawn. Keep in mind, however, that withdrawals from tax-deferred accounts are generally taxed at ordinary income-tax rates, even if the withdrawal consists of long-term capital gains or qualified dividends.
Over time, performance can change the makeup of any investment portfolio, and the way you originally allocated investments in the portfolio can shift, along with your exposure to investment risk. Since selling investments in a taxable portfolio can have tax consequences, if you are going to rebalance, you may want to direct your new investments to the underweighted categories until your portfolio is back in balance. In a tax-deferred portfolio, selling assets in the overweighted categories could be part of your rebalancing strategy.