Problem: Many investors are focused on tax-advantaged accounts like IRAs in their desire to maximize such tax advantages. Indeed, as income grows—through promotion or new jobs—then they begin to exceed the income limits to contribute to these accounts. The question becomes how one efficiently invests outside of these tax-advantaged accounts, particularly as it pertains to managing investments within a regular brokerage account. One also finds frequent uncertainty as to what to do with non–dividend-paying names and their interaction with the tax efficiency.
Platform: Conventional wisdom advises that investing via IRAs makes a lot of sense because of the tax-deferred or tax-free growth involved, but in reality, a taxable brokerage account could be just as tax-efficient a platform. With the right approach, you can manage your investments to minimize your tax liability even outside of retirement accounts.
Solution: Therefore, it is critically important to learn how to invest in tax-efficient manners within a taxable brokerage account. In other words, know how to manage both non–dividend-paying stocks and growth stocks in a tax-efficient manner. Being aware of these strategies will help you to engage in activities that respect your financial goals, even if investing outside of a tax-advantaged account.
That said, if you do choose to invest in a taxable brokerage account, it’s important to know the best ways to maximize tax efficiency. It does this through the capitalization of after-tax advantages in a taxable account and understanding of the different implications of income and gains.
Capital Gains Tax Rates
Among the advantages of a taxable brokerage account is that you get preferential tax treatment on long-term capital gains. That is to say, if you hold an investment for more than one year, the said investment is taxed at long-term capital gains rates. Generally, these are lower than ordinary income tax rates. That’s in contrast to an IRA, where all withdrawals really turn out to be ordinary income, no matter how much an investment has grown.
- Long-Term Capital Gains: Holding investments for more than a year provides a reduced tax rate that significantly impacts your overall taxation.
- Short-Term Capital Gains: Investments held for less than a year are taxed at your ordinary income tax rate, usually higher.
Dividends and Their Tax Treatment
Another important aspect of tax-efficient investing is dividends. There are two types of dividends: qualified and ordinary.
- Qualified Dividends: This is the kind of dividends that, by definition of the IRS, are taxed at the lower long-term capital gains rate. There is a certain duration for holding dividend-paying stock and some other requirements that must be met.
- Ordinary Dividends: They are taxed at your ordinary income tax rate. This is a higher level when you compare it to the rate applied on qualified dividends. Knowledge of the difference between the two should enable one to strategize his investments in a tax-efficient manner.
Investing in Non-Dividend Paying Stocks
Investors who are concerned with the tax implications of dividend income may find non-dividend paying stocks very attractive. Growth stocks, for example, Amazon and Alphabet (Google), do not pay dividends, but the capital appreciation may be very significant.
Pros of Non-Dividend Paying Stocks
- Tax Efficiency: Because they do not pay a dividend and hence deal avoid dividend taxes, their gains are taxed as capital gains, which is potentially at a lower rate.
- Compounding Growth: These stocks tend to reinvest their earnings into the growth of the company and can create quite large capital gains with time.
How to Analyze Stocks That Do Not Pay Dividends
With respect to stocks that do not pay dividends, there are the following considerations:
- Growth Prospects: Invest in companies with strong growth prospects and competitive advantages.
- Valuation: One should ascertain whether the stock has a reasonable valuation vis-à-vis the growth in its business.
- Investment Horizon: Do remember that these are largely suitable for long-term holding due to their growth characteristics.
Tax-Efficient Strategies for Regular Brokerage Accounts
Even if you’re investing in a taxable brokerage account, there are strategies to increase tax efficiency and help minimize your tax liability.
Tax-Loss Harvesting
Tax-loss harvesting is when investments are sold at a loss to help offset gains from other investments; this may reduce your taxable capital gains and thereby lower your overall tax bill.
- Offset Gains: Losses offset taxable gains in the current year.
- Carry Forward Losses: Unused losses can carry forward to future years to offset future gains.
Asset Location
Asset location refers to placing one’s investments in the most tax-efficient accounts. For example:
- Tax-Deferred Accounts: Equity investments generating ordinary income and fixed-incurring high-yielding investments should be placed in accounts that are tax-deferred, such as IRAs.
- Taxable Accounts: Investments that come with preferential tax treatment, such as growth stocks, should be placed in taxable accounts in order to capture better long-term capital gains rates.
Rebalancing Strategies
If you rebalance your portfolio regularly, this not only ensures a systematic way of maintaining your target asset allocation but also creates several opportunities for tax efficiency.
- Minimize Any Tax Impact: This is done in several ways: Consider rebalancing in a way that minimizes any taxable transactions and potential gains.
- Use Tax-Advantaged Accounts: As long as one can, make use of the tax-advantaged accounts when rebalancing between asset classes to avoid triggering events with tax consequences.
Conclusion
Getting an investment done in the most tax-effective way is an effort that combines tax planning and investment strategy. The visibility and essential savings provided by IRAs and other tax-advantaged accounts are significant, but a brokerage account that is taxable is an effective way to pursue growth and efficiencies in a tax-efficient manner.
You can increase efficiency through tax by sticking to long-term capital appreciation, harvesting losses, and adopting location strategies for your assets. The use of non-dividend-paying securities like growth stock is another way to optimize the tax outcome when looking for capital appreciation.
Ultimately, you want to make sure you have an investment plan that will allow you to meet your financial goals while minimizing the negative impact of taxes on your investments. If you are concerned about how tax issues will impact your investment decisions, you may find it helpful to consult with a financial advisor to ensure that you are being as tax-efficient as possible based on your situation.