Minimizing Taxes on Your Investments

by Paul R. Ruedi, CFP®

Nobody likes paying taxes on the money they’ve worked hard to save and invest for their future. The taxes paid over a lifetime of investing can have a big impact on the amount of money that will be available to use for future spending, but often get overlooked when making investment decisions.

Fortunately, you have many options to minimize the taxes on your investment portfolio. Some of them are so simple anyone can do them, others are more complicated and may require the help of a professional. Let’s start with a few of the easiest.

A great first step is simply to hold tax efficient investments. Index funds generally have lower turnover than actively managed funds which means fewer capital gains distributions and a lower tax bill. You can also lower the amount of buying and selling that needs to be done in the management of your portfolio by holding fewer, more broadly diversified mutual funds rather than a whole bunch of less diversified niche funds.

If you are investing in a taxable account, find out if there are “tax-managed” or “tax-advantaged” versions of the same funds you are considering investing in. Tax-managed versions of funds usually hold almost identical investments as their counterparts, but are just managed in a way that considers taxes and aims to generate the best after-tax return possible.

Investors can take tax savings to the next level by investing in retirement accounts. In a traditional 401k or Individual Retirement Account (IRA) you invest before-tax dollars. When it comes time to file taxes, the amount you contributed is deducted from income and lowers your tax bill. The proceeds grow tax-deferred, but you eventually pay taxes on withdrawals at your ordinary income tax rate at the time of withdrawal.

In a Roth 401k or Roth IRA you invest after-tax dollars (that you have already paid taxes on), your investments grow tax-deferred, and if you follow all the rules you can withdraw the funds without having to pay taxes on gains. The original amount is considered return of principal, so you don’t have to pay taxes on that either.

These are just a few of the easiest options to minimize taxes on your investment portfolio.  In our column next week, we will cover a couple of the more complicated options to save on taxes. If you need help deciding if one of these strategies is right for you, it is worth your time to talk to a financial professional.

Paul R. Ruedi is a Certified Financial Planner™ professional with Ruedi Wealth Management in Champaign, Illinois.