Managing Taxes in Taxable Accounts

The following is an excerpt from Personal Investing: The Missing Manual.

Sometimes, you have to put higher-taxed investments into taxable accounts. For example, if you're saving for a short-term goal, stocks may be too risky, so you put your money in bonds or bond funds, or in a savings account. Or you may be saving for a goal that doesn't have a tax-advantaged account option. Don't worry. Although you shouldn't make investment decisions purely to avoid paying taxes, you can keep your investment taxes low with the following tactics:

• Buy and hold individual stocks and bonds instead of stock or bond funds. You don't pay capital gains on individual stocks and bonds until you sell them; fund managers may trade within stock or bond funds frequently, and you pay taxes on any gains from those trades. Sell individual securities in taxable accounts only to rebalance your asset allocation or because an investment hasn't panned out as you hoped.

• Buy municipal-bond funds or municipal bonds. If you want more bonds in a taxable account, purchase municipal bond funds. The federal government doesn't tax municipal bond income. In addition, you don't pay state taxes on municipal bond income if you buy municipal bonds issued by your state.

• Delay selling until the capital gains are long term. If you sell an investment before you own it for a year, you earn a short-term capital gain, which is taxed at ordinary income rates (for someone in the 25% tax bracket, that rate is 25%, versus the 15% for long-term capital gains). If you're close to the 1-year mark and the investment isn't in mortal danger, hold off on the sale until you pass the 1-year mark.

• Wait until the next calendar year to sell. If the end of the year is close, delay a sale until January. That way, you don't pay tax on the capital gain until the following year, which means you have a full year to use that money, for example, to earn interest on savings or invest in something else.

• Offset capital gains with capital losses. If you have capital gains and also have some losers you want to unload, sell the losers in the same tax year as the winners. Your capital losses offset your capital gains. This tactic is particularly effective for short-term capital gains, taxed at higher, ordinary income rates.

Note: If you have more than $3,000 in long-term capital losses, you can use those losses to offset long-term capital gains. However, if you don't have enough long-term capital gains to offset all of your long-term capital losses, you can deduct no more than $3,000 of a long-term capital loss in one tax year and must carry the remaining loss over to future tax years.

Comments

[Nick]

I agree with you that you shouldn't buy and sell based only on taxes. I think many times novice investors who try and game taxes end up reducing their net returns by buying and selling at the wrong times or taking on too much risk.

It's hard enough for people to invest on their own for gains. But I do agree that many of the suggestions, if done right, can help (if done right is the key). #1 is probably not worth it for a lot of "regular" people because it puts their financial future in the hands of only a few companies (unless they have a very big portfolio). The "value" of the hightened risk might offset the "value" of any tax benefit you'll be able to gain... I'm a big ETF guy for novice investors.

[MBTN]

Two things to add:

1. Mutual funds have what is called a "captial gains distribution". This is taxed at the capital gains rate and not the ordinary income rate. Yes, you are at the mercy as to when and what you get, but at least it is at the lower rate. Also, if you invest in a mutual fund right before its distribution (usually in December), you will get some of your money back that you invested in distributions and you will immediately have to pay taxes on that money. Some people feel that it is better to wait until after the distribution to invest in a mutual fund, but everybody's situation is different.

2. Muni funds and bonds usually have a lower yield than taxables, so take that into account before investing. If you are in a lower tax bracket, you might be better off investing in a taxable bond because the additional yield might offset the additional taxes. Again, depends upon your situation.

[Sherman Unkefer]

I agree, it's a mistake to make your decisions based on the tax penalties but it does guide my decisions. These are great points to consider even if trying to delay a sale until the next year is sometimes impractical. It does help to offset the penalties by dumping the low performers. Thanks for a great post!