While you should always keep the tax consequences of investment decisions in mind, it’s a mistake to let them drive those decisions. Why? Because the goals for each are fundamentally different: the goal of investing is to make money over the long run, while the goal of tax planning is to minimize losing money in the short run. A few examples of what can go wrong will illustrate the point.
Concentrating investment and credit risk. Municipal bonds are a great way to reduce your exposure to both federal and state taxes. While a municipal bond from any state shelters interest payments from federal taxation, only municipal bonds issued from within the state in which you live will lower your liability for state income taxes. For that reason, investors frequently confine their investments in municipal bonds to in-state issues. The problem with that is you concentrate your exposure to the risk that your home state could run into financial problems that could jeopardize your returns.
Holding onto an investment too long. The higher tax rate on short-term capital gains—those realized in less than a year—than on long-term gains encourages some investors to hold on to an investment too long. Stock prices can move quickly, and by holding on to a stock just because you want a more favorable tax rate can cause you to lose some or all of your profits or deepen the losses you’ve already suffered.
Selling an investment too soon. Conversely, investors can be tempted to sell a stock prematurely in an attempt to harvest capital losses to shelter capital gains. While it might be a good idea to exit a stock position before its losses mount, you could regret it if the stock you sold later experiences big gains. Selling may also leave a hole in your asset allocation strategy and diminish your portfolio’s level of risk-reducing diversification.
The proper approach to tax-efficient investing. That doesn’t mean that taxes are a good thing, or that you shouldn’t try to minimize the taxes your investments trigger. But there’s a wrong way to go about it—and a right way. And the right way consists of doing the following:
- Taking full advantage of tax-sheltered investment retirement accounts, like IRAs, 401(k) plans, and tax-sheltered annuities.
- Investing in municipal bonds only when they generate a higher after-tax rate of return and match your investment objectives.
- Selling stocks based on their intrinsic ability to generate gains or losses.
- Prudently culling losing stocks from your portfolio when harvesting capital losses.
Please call to review how these tax changes affect your investment and portfolio strategy.
Copyright © Integrated Concepts 2013. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.