Taxes are a big drag on investment performance, greater than either commissions or management fees.
There is a growing realization among taxable investors that it’s not what you earn that counts, but what you keep after taxes -- you want to maximize after tax returns.
Here are some components to tax-aware investing:
- Increase investment in tax-favored assets – High income taxpayers pay 40.8% on interest and 23.8% on long-term capital gains (LTCG).
- Deferring gain recognition - All things being equal, the lower the turnover ratio of a portfolio, the higher the effective growth rate will be and greater terminal wealth from the investment.
- Tax-aware asset allocation - Make asset allocations based on the returns after application of the effective tax rate on each asset class.
- Tax sensitive asset location – list your assets by tax cost. Put high tax cost assets (corporate bonds) in IRAs or other tax deferred vehicles; and keep low tax cost assets (i.e. municipal bonds and long-term capital gain (LTCG) assets) personally.
- Manage capital asset holding periods – strive for LTCG. The tax rate of long-term capital gains is almost half of short term capital gains (STCG).
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