Why Investments Are Key To Tax Savings

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Bill Harris is the founder of Evergreen. He’s run 11 fintech and cybersecurity companies, including TurboTax, PayPal, and Personal Capital.

Taxes are a hellish mess. The tax code, regulations and case law contain millions of words. This is a U.S. disease, and there are no prospects for sensible reform.

Former Defense Secretary Donald Rumsfeld wrote a letter to the IRS stating the tax code was so complex that, despite hiring an accounting firm, “I have absolutely no idea whether our tax returns and our tax payments are accurate.”

Except for those rich enough to hire tax advisors, most taxpayers are left to battle the system on their own. Tax preparation software is a huge help when filing your return, but it just reports what happened last year and doesn’t help reduce taxes this year. For people with complicated returns—the half of the households that own investments—there is an acute need for a forward-looking tax strategy to reduce taxes during the year, not just report the results after the damage has been done.

I’m not a tax attorney, and that’s a good thing. I still understand taxes from a taxpayer’s point of view. I ran TurboTax for 10 years and then founded Personal Capital, an investment advisory firm that grew to $23 billion in assets. I’ve been living at the intersection of tax, technology and investments throughout my career, and I know firsthand how bewildering taxes are to most investors.


There’s Not Enough Focus On After-Tax Returns

Investors are not getting help from the financial industry. Brokers, advisors and fund companies typically focus on pre-tax returns. Outside of offering 401(k) and IRA plans, they often leave investors on their own when it comes to understanding the tax consequences of their investments. I believe, however, that investors should focus almost exclusively on after-tax returns.

Tax is the single most important driver of investment performance, in my opinion. While stock selection within a portfolio can make a modest difference in the total return, tax strategy can make a much larger impact.

For example, if you make $250,000 taxable income as a single filer in New York City, you pay a total of 49.5% of the interest from your savings account to the government. That’s 35% federal, plus 3.8% net investment income tax, plus 6.8% New York state tax, plus the roughly 3.9% New York City tax. If you think you’re making 4% in a high-yield savings account, you are not. After taxes, you’re making 2%—less than the rate of inflation, as of this writing.

The difference is even more dramatic when it comes to assets such as stocks, which generate capital gains. The federal income tax rate on short-term capital gains is significantly higher than on long-term capital gains. In the example above, if you sold a stock you held for less than a year, you would pay the same 49.5% tax as you would on interest income. However, if you held it until next year, you would pay 0% now and significantly less than 49.5% when you sell. In addition, there are numerous strategies to offset, defer or even eliminate taxes on capital gains.

This is one of the reasons why retail trading apps are so dangerous for inexperienced investors. These platforms encourage users to make many quick trades without considering the tax impact of realized short-term gains.

Equity mutual funds, with average turnover ratios of 40%-100%, are guilty of the same thing. Many funds trade aggressively in an attempt to outperform their index, then do “window dressing” at the end of each quarter, all resulting in numerous short-term gains. In a quest for pre-tax alpha, they sacrifice after-tax results.

You Need To Consider Tax Mitigation Strategies

Another opportunity is asset location—putting the right assets in the right accounts. Many people think that, because retirement accounts have a long time horizon, they should put their “longer-term” stocks in a 401(k) or IRA and their “shorter-term” savings, CDs and bonds in taxable accounts. This is backward.

Interest-bearing assets are taxed the same as your ordinary income, so it makes more sense for them to be the first to go into tax-deferred accounts. Because capital gains-generating stocks are taxed at lower rates and you control when to realize any gains, they belong in taxable accounts. Perversely, if you put stocks into a retirement account, you’ve just converted the price appreciation from capital gains to ordinary income.

The more investments you have, the more important tax planning becomes. Powerful tax strategies include tax loss harvesting, gain deferral, asset location, tax-exempt securities, tax-deferred accounts, tax-deductible loans, familial gifting and donor-advised funds. When used in combination, these strategies can dramatically reduce your taxes and, in some cases, eliminate them altogether. But, you have to plan in advance and execute with discipline throughout the year.

You Owe It To Yourself To Legitimately Reduce Your Taxes

Is it legitimate to use the peculiarities of the tax code to your benefit? Congress, which passes the laws, and the courts, which interpret the laws, appear to say yes.

Judge Learned Hand (yes, that’s his real name) famously said, “Any one may so arrange his affairs that his taxes shall be as low as possible … there is not even a patriotic duty to increase one’s taxes.” Legislators write the tax rules to incentivize behaviors for public policy reasons. When you take advantage of a tax strategy—such as using a 529 plan to fund your child’s college education—you are behaving as intended.

The U.S. tax code will not get any simpler anytime soon. You owe it to yourself, your family and your future to understand the basic tax strategies that can save hundreds of thousands, or even millions, of dollars over a lifetime.

Pre-tax income doesn’t matter; after-tax income does. After all, it’s not what you earn; it’s what you keep.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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