As an investor, your first priorities should be 1) to develop an asset allocation strategy that aligns with your
investment objectives and risk profile, and 2) to select quality securities that support that strategy. Only after
that’s done should you turn your attention to taxes and identify opportunities to improve the tax-efficiency of
your portfolio.
Here are several planning strategies to consider:
• Make the most of tax-advantaged accounts.
Evaluate the tax-efficiency of each investment, based on
factors such as dividend yields, fund turnover, and expected growth. To the extent possible, tax-efficient
investments should be held in taxable accounts. Tax-inefficient investments should be held in tax-
advantaged accounts, such as traditional or Roth IRAs, qualified retirement accounts, or education
savings accounts. Tax-advantaged accounts may also offer opportunities to rebalance your portfolio tax-
efficiently by containing asset turnover, to the extent possible, within those accounts.
• Consider tax-efficient options.
Examine investment alternatives that offer similar benefits in a more
tax-efficient structure. For example, exchange traded funds (ETFs) typically generate fewer taxable
gains than comparable mutual funds, and index funds tend to be more tax-efficient than actively
managed funds.
• Analyze tax-exempt investments.
Consider tax-exempt investments, such as municipal bonds. But be
sure to calculate the tax-equivalent yield to determine whether the tax savings compensate for reduced
returns.
• Harvest losses.
Throughout the year, consider selling poor-performing investments to generate losses
that can be used to offset capital gains (plus up to $3,000 of ordinary income). You can even buy the
investments back, so long as you wait at least 31 days to avoid the wash sale rule.
• Watch out for short-term gains.
Gains on investments held less than a year are generally taxed as
ordinary income. There are several potential strategies for minimizing these taxes, including holding
these investments for at least one year, harvesting losses to offset short-term gains, and limiting short-
term gains (if possible) to tax-advantaged accounts.
Pay attention to basis.
If you buy shares of stock or mutual funds at different times, you can minimize
your gains when you sell a portion of your shares by selling the shares with the highest cost basis. To do
that, you should use the “specific identification method” and inform your broker which shares you wish
to sell. If you don’t, the first-in, first-out (FIFO) method is usually applied by default, which often
results in the lowest-basis shares being sold first, generating higher capital gains.
• Avoid year-end mutual fund purchases.
This is a common tax trap. Generally, mutual funds distribute
capital gains and other income near the end of the year. If you invest in these funds shortly before the
record date, you’ll be taxed on these distributions as if you had held the funds all year, without receiving
any benefit. That’s because the value of your shares will immediately drop by the amount of distributed
gains.
Tax season is an ideal time to consider these issues. An examination of your investment-related taxes for 2020
can reveal tax-saving opportunities for 2021.