Strategies for Generating Tax-Advantaged Income By: Stock Market Charlie

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Key Takeaways

• Municipal and U.S. government bonds provide different tax benefits. If your bond income is subject to taxation, placing these assets in a tax-advantaged account such as an IRA can protect interest income from immediate taxation.

• Separately managed accounts can assist in managing gains and utilizing tax loss harvesting.

• Qualified dividends are subject to taxation at long-term capital gains tax rates.

• Investors with higher incomes might consider tax-deferred annuities as a strategy to defer taxes on investment gains.

Taxes can quietly erode your investment income—but they don’t have to. With a few smart strategies, you may be able to build a stream of income that receives preferential tax treatment. Understanding the nuances of how different types of income are taxed is crucial for maximizing your returns. Many investors overlook the impact of taxes on their overall investment strategy, which can lead to a significant decrease in net income over time. By being proactive and informed, you can take steps to minimize the tax burden on your investment earnings, thereby enhancing your overall financial health.

These 6 tips can help you make your income portfolio more tax-efficient, whether you're investing in bonds, dividends, or managed accounts. The following strategies not only aim to reduce your tax liability but also help in optimizing your investment approach to align with your long-term financial goals. Each tip is designed to provide you with actionable insights that can be tailored to your specific financial situation, ensuring that you are not only growing your investments but also protecting them from unnecessary taxation.

1. **Utilize Tax-Advantaged Accounts**: One of the most effective ways to shield your investment income from taxes is by using tax-advantaged accounts such as IRAs, 401(k)s, or Health Savings Accounts (HSAs). Contributions to these accounts can often be made pre-tax, and the growth within these accounts can occur tax-deferred or even tax-free, depending on the account type. This means that you can reinvest your earnings without the immediate tax implications, allowing your investments to grow more significantly over time.

2. **Consider Tax-Efficient Investments**: Some investments are inherently more tax-efficient than others. For example, municipal bonds often provide interest income that is exempt from federal taxes, and in some cases, state taxes as well. Additionally, index funds and exchange-traded funds (ETFs) typically have lower turnover rates than actively managed funds, which can result in fewer taxable events. By choosing investments that align with your tax strategy, you can enhance your portfolio's overall tax efficiency.

3. **Strategic Asset Location**: The concept of asset location involves placing your investments in the most tax-efficient accounts. For instance, it may be beneficial to hold high-yield bonds or actively managed funds in tax-deferred accounts where they can grow without immediate tax implications, while placing lower-yield investments, like index funds, in taxable accounts. This strategy helps in optimizing your tax situation by ensuring that you are minimizing taxes on your highest-returning assets.

4. **Take Advantage of Capital Gains Tax Rates**: Long-term capital gains are usually taxed at a lower rate than ordinary income. By holding investments for more than a year before selling, you may qualify for these reduced rates. This can be particularly advantageous if you plan to sell assets to realize gains. Additionally, understanding the thresholds for capital gains tax can help you plan your sales in a way that minimizes your tax burden.

5. **Harvest Tax Losses**: Tax-loss harvesting involves selling investments that are underperforming to offset gains from other investments. This strategy can help you reduce your taxable income for the year. By carefully managing your portfolio and making strategic sales, you can effectively lower your tax liabilities while maintaining a balanced investment approach. It is essential, however, to be mindful of the wash-sale rule, which disallows the deduction of losses if you repurchase the same or substantially identical security within 30 days.

6. **Stay Informed and Adjust Your Strategy**: The tax landscape is constantly evolving, with changes in tax laws and regulations that can impact your investment strategy. Staying informed about these changes and regularly reviewing your investment portfolio can help you adapt your strategies to remain tax-efficient. Consulting with a tax professional or financial advisor can provide additional insights tailored to your unique financial situation, ensuring that you are making the most of your investment income while minimizing tax liabilities.

PART TWO

1. Municipal bonds

Municipal bonds, commonly referred to as "munis," provide interest income that is typically exempt from federal income tax, and often from state and local taxes if you reside in the issuing state. This tax advantage makes them particularly appealing to high-income investors and individuals in states with elevated tax rates. Although the coupon yields of municipal bonds may be lower than those of taxable bonds, the favorable tax treatment can compensate for the lower yields. Investment options for munis include purchasing individual bonds, bond funds, ETFs, or utilizing separately managed accounts.

This hypothetical example illustrates the annual income from a $10,000 investment in a taxable account and how it's affected by the four highest federal tax rates and the net investment income tax (NIIT). The municipal bond investment assumes a 2.63% yield, while the taxable US Treasury yield is assumed to be 4.34% (data from LSEG TM3, formerly Refinitiv TM3, as of 11/30/23). Actual investments may differ. It does not account for state taxes, federal or state alternative minimum taxes, tax credits, exemptions, fees, or expenses, which could further reduce after-tax income. For more details, consult a tax professional.

2. US Treasurys

US Treasury securities are exempt from state and local taxes but are subject to federal taxes on ordinary income and net investment income. For investors in high-tax states, this feature can make Treasurys a more efficient fixed income option. They provide safety and liquidity, making them a reliable core holding in tax-aware fixed income portfolios. Newly issued Treasurys can be acquired at government auctions, while previously issued bonds are available on the secondary market.

Chart detailing various types of U.S. Treasury securities, highlighting their minimum denominations, sale conditions, maturities, and interest payment structures.

3. Taxable Bonds and CDs in Tax-Advantaged Accounts

Placing taxable bonds and CDs in tax-advantaged accounts such as IRAs or Roth IRAs can protect interest income from immediate taxation. This approach enhances the compounding effect of reinvested interest and eliminates the burden of annual tax payments. Conversely, consider utilizing tax-efficient assets like index funds in taxable accounts to potentially optimize your overall portfolio.

Comparison of Investment Options: This table outlines the tax treatment of expected returns for various investments, helping investors identify the most suitable account types—taxable, tax-deferred, or tax-exempt. Municipal bond funds are generally exempt from taxes, while high-turnover mutual funds are taxed at ordinary income rates.

4. Separately Managed Accounts

Separately managed accounts (SMAs) employ various tax-efficient investment strategies to enhance after-tax returns.¹ These strategies include tax-loss harvesting, a technique that minimizes annual capital gains tax by selling depreciated assets to offset realized taxable gains. If you incur a net realized loss by year-end, you may deduct up to $3,000 ($1,500 if married filing separately) or your total net realized losses, whichever is lower, from your ordinary income and carry forward any remaining unused losses to subsequent years. The outcome: Reduced tax liability today.

For investors who prefer not to engage in tax-loss harvesting themselves, an SMA provides an effective means to manage taxable gains. SMAs also offer transparency and control over the timing of taxable events.

Investors may opt for a traditional separately managed account, which involves collaborating with an advisor to formulate your strategy, or an online-only option.

Illustration detailing the process of a separately managed account (SMA), where a manager creates a unique portfolio of stocks and bonds for each investor based on specific objectives. Unlike mutual funds, investors in an SMA own the underlying shares, allowing for personalized investment decisions.

5. Qualified Dividends

Dividends are not uniformly taxed. Qualified dividends, which are generally distributed by U.S. corporations and held for a specified minimum duration, are subject to taxation at long-term capital gains rates, offering a tax advantage over ordinary income rates. Investing in companies with a track record of issuing qualified dividends can improve after-tax returns, particularly in taxable accounts.

Table outlining the criteria for qualified dividends, including holding period requirements, eligible payer types, exceptions, and tax implications.

6. Tax-Deferred Annuities

While not suitable for everyone, tax-deferred annuities can be beneficial for investors seeking to postpone taxes on investment gains, especially high-income individuals who have already maximized contributions to tax-advantaged retirement accounts.

By allocating a portion of your savings to a tax-deferred variable annuity, any earnings will grow tax-deferred.² In the future, you have the option to convert it into an income annuity for a consistent income stream or make withdrawals as needed. At that time, any earnings will be taxed as ordinary income.

Tax-deferred annuities are most effectively utilized when other tax-advantaged accounts, such as a 401(k) or IRA, have been fully funded, and when combined with a well-defined plan for withdrawal timing and income requirements.

Comparison of potential investment values over 20 years at a 6% rate of return: a $100,000 taxable account grows to $222,508, a tax-deferred annuity pre-tax reaches $305,053, and post-tax with lump-sum withdrawal totals $239,436, factoring in a 0.25% annual annuity charge.

Conclusion

Whether you are beginning your investment journey or overseeing a complex portfolio, tax-aware investing can optimize your financial outcomes. By integrating prudent tax strategies into your investment approach, you can develop a portfolio that is both efficient and robust.

Best Regards,

Stock Market Charlie