Potentially boost your after-tax returns with these four strategies.
Overlooking the potential impact taxes can have on investment returns is one of the most common mistakes investors make—especially high-net-worth ones. It can cost you. According to Morningstar, those who didn’t manage investments with taxes in mind gave up between one and two percent of returns to taxes.1 As the chart to the right shows, on average, over the 85-year period ending in 2011, a hypothetical stock return of 9.8% shrank to 7.7% after taxes. That would have left the investor with 2.1% less investment income in his or her pocket.
“When investment returns are high, investors tend to lose sight of the potential impact of taxes,” says Chris Fusé, vice president of investment management at Fidelity. “But when returns are more modest, you can very clearly see that taxes are as important a consideration as performance and fees.”
Taxes, however, aren’t as inevitable as you might think. With careful and consistent planning, you can potentially reduce their impact on your returns through tax-efficient investing. We recommend consulting with a tax advisor, financial planner, or estate planning attorney to help you make the right tax moves for your particular situation—or to confirm that your current approach is still sound.
Here are four tax-savvy strategies to consider.
1. Use tax efficient accounts
The type of account in which you invest is important for tax-efficient investing.
When saving for retirement, a qualified workplace savings plan, such as a 401(k) or 403(b), allows you to contribute pretax dollars that can potentially grow tax deferred until they’re withdrawn after age 59½. If your employer offers a Roth 401(k), you can avoid taxes entirely on your earnings, provided certain conditions are met. A tradeoff: You cannot contribute pretax dollars and contributions are not tax deductible in the year you make them.
Another workplace plan, a health savings account (HSA) with a high-deductible health insurance plan, is another way to potentially save on taxes. While most HSA account holders use their HSAs to pay for current qualified medical expenses, many are using them to save for medical, or other expenses during retirement.
A Roth IRA also allows your investments to grow tax free, but there are income limits for contributions. In 2012, the limits for single filers is income up to $110,000 for a full contribution, $110,000 to $125,000 for partial contributions. For joint filers the 2012 limit is $173,000 for a full contribution, $173,000 to $183,000 for partial contributions. In 2013, the limits for single filers is income up to $112,000 for a full contribution, $112,000 to $127,000 for partial contributions. For joint filers the 2013 limit is $178,000 for a full contribution, $178,000 to $188,000 for a partial contribution. If your income is over the limit and you or your spouse don’t have a retirement plan at work, you may be able to make a tax-deductible contribution to a traditional IRA for tax-deferred savings. Another way to have a Roth IRA would be to convert money from an existing retirement account such as a traditional IRA.
And don’t forget about tax-deferred annuities. Taxes aren’t due on any earnings2 until they’re withdrawn in retirement, and there are no annual contribution limits,3 unlike an IRA or 401(k) plan.
2. Match investments with account type
A well-thought-out asset allocation strategy can play a key part in helping to reduce a portfolio’s overall risk and boost reward potential. But there’s another important companion strategy that many investors often overlook. Known as “asset location,” it involves deciding which investments to own in a taxable, tax-deferred, or tax-free account. This strategy can potentially help reduce the tax impact.
For example, you may want to consider owning relatively tax-efficient investments—such as stocks or mutual funds that pay qualified dividends, stock index funds, and tax-managed stock funds—in your taxable accounts.
If generating income is one of your investment goals, you may want to consider using a taxable account to invest in tax-free municipal bond and money market funds—especially if you’re in a high tax bracket. These funds typically invest in bonds issued by municipalities and their earnings are generally not subject to federal tax. You may also be able to avoid or reduce state income tax on your earnings if you invest in a municipal bond or money market fund that holds bonds issued by entities within your state. Interest income generated by most state and local municipal bonds is generally exempt from federal income and/or alternative minimum taxes. But if these bonds were used to pay for such "private activities" as housing projects, hospitals, or certain industrial parks, the interest is fully taxable for taxpayers subject to the AMT. A fund's prospectus will tell you if it aims to generate only AMT-free interest dividends.
It may make sense to use tax-deferred accounts such as 401(k)s, 403(b)s, traditional IRAs, and tax-deferred annuities for investments that generate high levels of ordinary income. That means taxable bond funds and real estate investment trusts, as well as stock funds that tend to make large and frequent capital gain distributions—particularly short-term capital gains.
Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.
1. Taxes Can Significantly Reduce Returns data, Morningstar, Inc. 3/1/2012. Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $110,000 in 2010 dollars every year. This annual income is adjusted using the Consumer Price Index in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs. When realized, capital gains are calculated assuming the appropriate capital gains rates. The holding period for capital gains tax calculation is assumed to be five years for stocks, while government bonds are held until replaced in the index. No state income taxes are included. Stock values fluctuate in response to the activities of individual companies and general market and economic conditions. Generally, among asset classes stocks are more volatile than bonds or short-term instruments. Government bonds and corporate bonds have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. U.S. Treasury bills maintain a stable value if held to maturity, but returns are generally only slightly above the inflation rate. Although bonds generally present less short-term risk and volatility than stocks, bonds do entail interest rate risk (as interest rates rise, bond prices usually fall, and vice versa), issuer credit risk, and the risk of default, or the risk that an issuer will be unable to make income or principal payments. The effect of interest rate changes is usually more pronounced for longer-term securities. Additionally, bonds and short-term investments entail greater inflation risk, or the risk that the return of an investment will not keep up with increases in the prices of goods and services, than stocks.
2. Earnings will be taxed at the income tax rate in retirement.
3. Fidelity reserves the right to limit contributions.
4. Fidelity® Personalized Portfolios applies tax-sensitive investment management techniques (including tax-loss harvesting) on a limited basis, at its discretion, primarily with respect to determining when assets in a client’s account should be bought or sold.
Past performance is no guarantee of future results.
Neither diversification nor asset allocation ensures a profit or guarantees against loss.
The municipal market can be affected by adverse tax, legislative, or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a money market security to decrease. Municipal funds normally seek to earn income and pay dividends that are expected to be exempt from federal income tax. If a fund investor is resident in the state of issuance of the bonds held by the fund, interest dividends may also be exempt from state and local income taxes. Such interest dividends may be subject to federal and/or state alternative minimum taxes. Certain funds normally seek to invest only in municipal securities generating income exempt from both federal income taxes and the federal alternative minimum tax; however, outcomes cannot be guaranteed, and the funds may sometimes generate income subject to these taxes. Fund shareholders may also receive taxable distributions attributable to a fund's sale of municipal bonds. Generally, tax-exempt municipal securities are not appropriate holdings for tax-advantaged accounts such as IRAs and 401(k)s.
An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although money market funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in these funds.
The tax and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Fidelity does not provide legal or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Fidelity makes no warranties with regard to such information or results obtained by its use. Fidelity disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Fidelity® Personalized Portfolios is a service of Strategic Advisers, Inc., a registered investment adviser and a Fidelity Investments company. Fidelity® Personalized Portfolios may be offered through the following Fidelity Investments companies: Strategic Advisers, Inc., a registered investment adviser; Fidelity Personal Trust Company, FSB (“FPT”), a federal savings bank; or Fidelity Management Trust Company (“FMTC”). Non-deposit investment products and trust services offered through FPT and FMTC and their affiliates are not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency, are not obligations of any bank, and are subject to risk, including possible loss of principal. These services provide discretionary money management for a fee.
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