10 portfolio strategies to help save on your income tax bill

With the passing of the April 15 tax-filing deadline, most people have now felt the impact of the changes to the tax code. For many, the loss of significant itemized deductions may have them re-examining their tax return for tax savings opportunities. As a result, it may be a good time to review the impact your investment portfolio may be having on your income tax bottom line.

Taxes matter a lot. Although every taxpayer’s situation is different, it has been estimated that proper tax management of your portfolio may be able to improve your after-tax returns by 1–2 percent a year. While this seems like a small amount in any single year, the long-term compounding benefit could be significant!

If you have taxable investments outside of retirement accounts like IRAs and 401(k)s — retirement accounts don’t pay income tax until the funds are taken out — then there are multiple strategies to help control income taxes. Here are 10 such strategies:

1. Mutual funds with tax-sensitive mandate

Some or all of your portfolio could include mutual funds that have tax minimization as part of their mandate. The managers of these funds, as part of their investment approach, are required to minimize tax distributions to shareholders, so they utilize some of the strategies discussed in this article. Mutual funds don’t pay income taxes. Instead, they distribute all of the income and gains out to shareholders who pay the tax. It may come as a surprise to many investors, but unless the fund manager is explicitly required to minimize taxes, then the manager is not likely doing so. We highly recommend reviewing the fund prospectus carefully before purchasing a mutual fund. Prospectuses are required to disclose the fund’s strategies, among other things, including whether tax minimization is part of the strategy.

2. Municipal bonds

Tax-exempt municipal bonds can be used instead of corporate bonds to provide tax-advantaged income. If you are in a federal tax bracket of 24 percent or higher, you should consider investing in municipal bonds. Interest on these bonds will not be taxed for federal purposes, but rather only as state income (state rates are generally much lower than federal rates). In some states the bonds may be tax free for both state and federal, depending on the type of bond.

3. Qualified dividends

Certain dividends known as qualified dividends are subject to the same tax rates as long-term capital gains, which are lower than rates for ordinary income. To qualify for the lower capital gain rate, qualified dividends are generally dividends from shares in U.S. corporations and certain qualified foreign corporations that you have held for at least a specified minimum period of time (too complicated to dive into for this article). The qualified dividends are reported separately on year-end tax reporting statements. If a significant portion of your dividends are not in this “qualified” bucket, then you may want to discuss the matter with your financial advisor/broker and/or tax advisor.

4. Tax-loss harvesting

Tax-loss harvesting is used to sell securities at a loss to offset taxable gains now or in the future. Almost everyone had some losses in 2018 as markets declined significantly in the fourth quarter. Did you take advantage of this downturn? Tax-loss harvesting involves selling an investment at a loss and immediately reinvesting the proceeds of the sale back into the same asset class. This allows you to secure a loss to offset gains on your tax return, without compromising your investment strategy and the overall makeup of your portfolio. In addition to offsetting gains, you can deduct capital losses up to $3,000 against ordinary income on your federal tax return. As markets recover, you have both the recovered value of the portfolio and a tax loss to use on your tax return.

5. Minimize trading

The more trading that occurs in the portfolio, the more tax that will likely be incurred on the realized gains. If you are seeing a lot of trades on the year-end tax reporting statement, discuss with your broker/advisor the reasons for the trades. It could be a red flag. This is a particular area where many investors simply defer to their advisor’s assumed knowledge. Frequent trading often leads to higher expenses (see next paragraph) in the portfolio and does not necessarily achieve the investor’s goals and objectives.



6. Hold investments longer than one year

Investments held for more than one year (366 days or more) are taxed at capital gains rates, while investments held for one year or less are taxed at ordinary income rates. For the vast majority of taxpayers, capital gains taxes will be lower than ordinary income rates. If your tax return reflects a number of sales held for one year or less, then there is a possibility that your broker/advisor may be disregarding the tax consequences of transactions, and you may be paying more in tax than you should.

7. Tax lot accounting

When you need to take gains, consider selling those shares with the lowest income tax impact first. This requires carefully reviewing the tax basis for all shares that are held. This will generally mean selling any shares with a loss first, then selling the shares with a long-term gain and the highest basis next. Discuss these aspects with your advisors/broker to make sure they are paying attention to this. If for simplicity and easy recordkeeping they simply sell the shares with the lowest basis first, it may cause a higher tax bill for you!

8. Donate appreciated shares

If you are able to itemize charitable deductions, you may want to consider gifting highly appreciated stock or shares of mutual funds (held for more than one year) rather than cash. The cash can then be used to reinvest at a higher basis or be used to fund living expenses. You will not only avoid capital gains tax by not selling the stock but also benefit from a deduction equal to the fair market value of the stock. Be aware that if you donate stock you’ve held less than a year, the deduction will be limited to cost basis. If a stock has lost value, it’s probably better to sell it, capture a capital loss, and donate the cash.

9. Qualified charitable distributions

If you are over 70.5 years old and make gifts to charity, then you should consider a qualified charitable distribution (QCD), which allows you to gift up to $100,000 directly from your IRA to a qualified charity. Any amount processed as a QCD counts toward the required minimum distribution (RMD) and reduces the taxable amount of the IRA distribution. This approach will lower both your adjusted gross income (AGI) and taxable income, resulting in lower overall tax liability. Taxpayers who do not expect to itemize in 2019 and need to take an RMD in 2019 would be prime candidates for this strategy.

10. Take IRA distributions or complete Roth conversions early if in low income tax bracket

If you are in a federal tax bracket of 22 percent or lower (certainly if you’re in the 12 percent bracket or lower) and over the age of 59.5, consider taking some distributions from your retirement accounts (IRAs and 401(k)s) or completing Roth conversions before the required age of 70.5. Why would anyone ever want to pay tax early? Because you will likely be required to take larger distributions from your IRAs after age 70.5 that may push you into even higher tax brackets then. If so, you want to use up these lower tax brackets now because you will never have the opportunity again to take the distributions or complete Roth conversions at such a low tax bracket. The prime candidates for this strategy are taxpayers who are retired over age 59.5 with little income (i.e., before you start taking Social Security payments or if you only have small Social Security payments).

Annuities as a tax-savings strategy

One note on annuities as a tax savings strategy. Annuities can defer income tax and are often marketed as a tax savings strategy. However, many annuities also have high fees and sales charges, and they can lock up your funds for many years. Finally, all of the gains distributed from an annuity are taxed as ordinary income instead of the likely lower capital gains tax rates. There may be better tax-savings strategies outlined above compared to the potential overall cost of annuities.

Are any or all of these tax strategies being utilized in your portfolio?  If not, you may be missing out on tax savings that are available to you!

Dean T. Stange, JD, CFP, is a principal and senior financial advisor at Wipfli Financial Advisors LLC.

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