Financial Planning: Tax Efficiency Part II (Investment-related Taxes)

Here I discuss financial planning strategies for reducing the amount of investment-related taxes one may pay. Investment-related taxes are those which apply to dividends, bond interest, rental income, etc. in taxable accounts.

Hi everybody thanks for taking the time to watch this video my last video focused on tax efficiency but that was in the context of income taxes this video is also going to focus on tax efficiency but in the context of investment related taxes so those are taxes related to dividends bond interest rental income and capital gains this only applies to taxable accounts

So those are accounts like your taxable brokerages your living trust your other kind of trust it doesn’t apply to retirement accounts iras 401ks and things like that i’m going to discuss 10 ideas or 10 strategies to reduce these investment related taxes some of these are pretty well known but some of them aren’t the first idea is to invest not trade i know a

Lot of people out there like to buy and sell stocks and other investments but when you do that you trigger unnecessary taxes and when you pay these taxes that means you’re reinvesting less money and reducing your long-term rate of return because you’re reducing the amount that’s being compounded through time the second idea is to use low turnover investment

Products even if you’re not trading yourself you don’t want to use mutual funds or other portfolio managers that do do that because the same taxes still apply when you use these types of funds or these types of portfolio managers you end up paying taxes in the current year reinvesting less and reducing your long-term rate of compounding the third idea is to

Use exchange-traded funds or etfs i like to say etfs are the best invention for the taxable investor in the history of investing and the reason i say this is because etfs got a special blessing from the irs so that even if the managers are buying and selling stocks within an exchange-traded funds they don’t end up distributing capital gains to the investors in

The etfs like mutual funds do i won’t go into the technicals of the creation redemption process and the in-kind transactions that earned etfs this blessing but i can tell you etfs are some of the most tax efficient investment vehicles you can find the next idea is to be careful with high-yield investments whether those are high yielding dividend stocks or funds

Or high yielding bonds or bond funds the idea is that the yield itself is completely taxable so when you have an investment that has a lot of yield rather than capital appreciation that yield is taxable in the year that it’s paid that makes these types of high-yield investments increasingly tax inefficient it’s also worth mentioning that high-yield investments

Typically have these high yields to compensate for some other risk that’s lurking with the fundamentals of the investment this brings us to the next idea of investing in things like municipal bonds where there’s no tax on the interest for these types of bonds however you want to be careful even though you’re not paying taxes on the interest from the municipal

Bonds the interest or the yield might be lower than other types of bonds in fact it might be so much lower that you could get more interest or more return by using say a corporate bond or a treasury and paying taxes on it where you would get a higher income after paying the taxes so you want to do the math and make sure that the after tax yield is higher on the

Municipal bond in general municipal bonds are going to be more favorable for higher tax bracket folks because those people have more taxes on the income from bonds now we’re just over the halfway mark and the next idea i’m going to discuss is tax harvesting now many people might already be familiar with the idea of tax loss harvesting the main idea there is just

To sell investments that are trading at a loss inside of your portfolio to lock in those losses when you do that if if you sell something for a game down the road those losses will be netted against the gains thereby reducing your tax bill however the other side of tax harvesting that a lot of people aren’t familiar with is tax gain harvesting it turns out the

Irs is actually very generous providing a large zero percent capital gains tax bracket so if you have investments that are trading at a gain and you have capacity within that zero percent tax bracket for capital gains it’s generally beneficial to sell some of those gains buy them back at a higher price so that if and when you do sell that investment down the

Road it will have a higher cost basis therefore a lower capital gain and a lower tax bill the next idea or strategy is to use step ups and basis to your advantage that is when people hold investments throughout their whole life when they pass and pass those assets onto their errors their heirs receive a step up in basis no matter if those assets had very low

Cost basis and had huge capital gains when the heirs receive inherit those assets they receive those assets at current market value and can thus sell them without triggering any capital gains it’s worth noting that this can happen between spouses as well i discussed some examples within my blog article on this topic the next idea is to have a strategy for how

You withdraw your money from various accounts during retirement the conventional strategy that a lot of people use is to first pull money out of their taxable accounts then their tax deferred accounts like iras and 401ks and then leaving their roths last however this sequence is almost never optimal it’s quite complicated to figure out the right strategy and it

Almost always requires software to figure this out however it’s very important can make the difference of tens if not hundreds of thousands of dollars during retirement here i’m sharing an illustration from my financial planning software and it shows the different colors show the different accounts from where money should be pulled out throughout retirement as you

Can see there doesn’t look to be an obvious trend or strategy here it’s very complicated in order to minimize the taxes throughout retirement it’s very easy to get this strategy wrong i’ve seen multiple instances of clients who are in the 12 percent tax bracket who need just an extra a few hundred bucks or a few thousand bucks for something during retirement and

They end up pulling it out of say their traditional ira but even though they’re in the 12 tax bracket the math works out that the marginal tax on say that extra thousand dollars that they pull out it gets taxed it triggers taxes on the order of fifty percent of the amount they pull out so they went from a twelve percent marginal rate to a fifty percent marginal

Rate because they didn’t use a proper withdrawal strategy now we’re on to the next to the last idea and that has to do with annuities when you annuitize money the irs gives a special treatment to the taxation of the annuitized income in particular they use something called the exclusion ratio to determine how much of that income each year is taxable versus not

Taxable and this exclusion ratio effectively levels out the taxation throughout your retirement and that’s a very important advantage if you were to structure similar type of income with say a bond ladder the taxation in that scenario is going to be much higher in the front in other words the taxes are front loaded i’ve written extensively on this topic and

It’s very complicated people get this mixed up and there’s one detail that i see people getting mixed up over and over and that’s the difference between annuitization where you do get guaranteed money for the rest of your life and you do get the exclusion ratio treatment however when people use guaranteed income riders the tax treatment is completely different

All the profits come out of these products first are taxed fully as ordinary income depending upon your circumstances annuitization with the exclusion ratio or the front loaded taxation with the guaranteed income riders could be advantageous but you have to look at your specific details to make that decision and finally we’re on to the very last idea and that

Is how to use life insurance when you put money into life insurance that money can grow tax-free until it is ultimately distributed as a death benefit tax-free as well so there’s no tax on the growth and there’s no tax on the distribution that much is pretty common knowledge however what a lot of people don’t realize is that if you structure your life insurance

Policy properly you can also make withdrawals or take loans out of your insurance policy your life insurance policy during your lifetime tax-free you have to make sure you structure your policy correctly or else those tax benefits can go out the window however you can effectively use your life insurance double duty both for the death benefit but also for liquidity

During your lifetime so that’s it from me i hope you found this video useful and there’s something in there that can save you some money or some taxes if you have any questions please feel free to reach out you can go to my website use a contact page set up a free consultation whatever you prefer but thanks again for watching you

Transcribed from video
Financial Planning: Tax Efficiency Part II (Investment-related Taxes) By Aaron Brask Capital