Tax efficient investing
by Craig Pellet, CPA
Investing is about earning money, and earning money means paying tax. Here are some tips to keep the tax hit on your taxable portfolio low, and your after-tax investment returns high.
Avoid mutual funds. Use ETFs instead
Both mutual funds and ETFs must distribute the capital gains realized by the fund annually. But ETFs have a structural advantage. Generally, they don’t need to sell assets within the fund to pay redemptions the way a mutual fund does. That means they are far less likely to have any capital gains to distribute at all. In fact, only 4% of ETFs distributed any capital gains in 2024. And even then, the average distribution was low, only about 1% of net asset value. Mutual funds are still great investing tools, but keep them in your tax-deferred accounts, like IRAs or 401(k)s, and out of your taxable accounts.
Use municipal bonds, but only if you’re in a high tax bracket
Municipal bonds are generally free from federal tax. They can also be free from state tax if you reside in the state that issued the bond. However, you give up some yield for these tax benefits. On average, the yield on a municipal bond is about 30% lower than that of a similarly rated taxable bond.
Consider municipal bonds that are tax exempt in your resident state only if you are in the 32% tax bracket or higher. For 2024, that means a single filer with taxable income (that is, income after the standard deduction or itemized deductions) earning over $197,300, or married couples earning over $394,600. [problem with this is now we need to remember to update for 2025 or later years!]
Avoid short-term gains
Taxes on short-term gains are really high. Generally they are subject to ordinary income tax rates, which top out at 37%. If your adjusted gross income is over $200,000 for single filers or $250,000 for couples, you can tack on another 3.8% Medicare tax. Then consider state tax. In a high-tax state, the total hit can be 50% or so! Hold assets for longer than one year to cut that tax rate down a lot.
Get qualified dividends
Most corporate dividends are taxed at relatively low capital gains rates. There are exceptions. Real estate investment trusts generally distribute ordinary income, taxed at a top federal rate of 37%. Dividends from some foreign corporations are also subject to these higher rates. Any of these can be useful investments, despite the differences in tax treatment. And, in tax-deferred accounts, there’s no tax at all.
With MLPs – go big, or go home
MLPs, or master limited partnerships, often provide tax benefits. Generally, investors are subject to tax on their share of an MLP’s profit, regardless of what’s distributed. This structure is typically used by businesses that can pass losses to investors, while tax free cash is distributed. However, MLPs make tax preparation much harder. Each detail of the MLPs income must also be reported on your return. These businesses also operate in many states, and you may have to file tax returns in each of those states as well. All of this is worth it if the numbers are big. But if they are small, the effort or expense to account for it might not be worth the benefit.
At John Schachter + Associates we help our clients minimize the tax they owe on their investments. Talk to us. Let us know how we can help you!
