Tax Aware Investing

Tax Aware Investing

Tax Aware Investing: Why It Matters and Where You Can Find Help

With traditional tax-advantaged vehicles like the 401(k), 403(b) and Traditional IRA, there’s a lot to consider when it comes to setting up your personal finance strategy. With tax aware investing, investors can make sure they’re getting the most tax savings from their investments while still tracking their savings and expenses efficiently. Maybe even how to avoid investment tax.

Tax aware investing is a set of services that tracks users’ spending habits and determines which investments will help them achieve their financial goals while also lowering their taxes. According to Investopedia, this type of investing uses algorithms to determine the total cost of ownership for each investment and offers recommendations based on a user’s unique situation.

If you are looking for ways to optimize your personal finances with regard to taxes – read on for more details about tax aware investing as well as some other options that may be right for you.

There is much truth to the expression “It’s not what you make,” It’s what your keep. It’s a good time to remind yourself that taxes are an integral part of any financial plan and investment decision. Why?

Investors who are focused on the long-term should consider how taxes affect total returns over time. Financial advisors and tax professionals are able to work together to develop a plan that maximizes your chances of reaching your financial goals. An ideal tax aware portfolio!

Tax Planning Versus Tax Preparation

Many people don’t think about taxes until it is too late. This happens after the year ends, when they begin to gather the information necessary to prepare their tax return. They fail to take a multi-year, big-picture approach to building and conserving wealth over time.

It is important that you understand the difference between tax planning and tax preparation. Tax preparation looks backward and uses information from the previous year. While a tax return may be completed correctly according to IRS guidelines, it fails to address how to minimize the tax consequences of investment decisions.

Tax planning involves ongoing dialogue, goals-based planning, investments, and risk management. Long-term wealth accumulation should not be achieved through tax preparation, but rather tax planning.

A Framework to Move Beyond the Current Year

Tax aware investingTaxes are the largest expense most families will incur in their lifetime. Your financial planner and your tax professional should work together in an ideal world. If this is not the case there are options for you, as an investor, to ensure you have the right framework in place to receive the advice you require.

A framework that integrates tax and financial planning will have a 3- to 5-year time horizon and include long-term retirement goals. The framework’s core component is a realistic, goals-based plan that can be updated for changing circumstances. This allows interim goals to account both for income and potential short-term windfalls.

  • Compare the amount of your IRA balance that you can convert to a Roth IRA now and your target retirement date, with how much you can convert during the current calendar year.
  • You should request a more detailed plan when you reach about 5-10 years of retirement. This will include a review of your expected expenditures and where the funds will be coming from in order to fund them in a tax-efficient way.

The Right Guidance

Wealth management has been focusing more on tax planning, and there is an increase in the number of financial professionals who are qualified to offer tax-savvy advice.

Working with a tax expert in addition to your financial advisor is a great advantage. Integrating these two areas will ensure you receive seamless financial and tax advice. If this is not possible, ask your tax professional which partner they have for long-term financial advice.

If you have different tax and financial professionals, make sure they are connected at least once a year and when making major life decisions. Your wealth manager should suggest it. If not, you should request it. These meetings should include a review of your current financial situation and any anticipated changes.

Remember the difference between tax preparation, and tax planning. If you don’t work to minimize taxes or create a plan, you can prepare a tax return in all aspects and still not add value.

Let’s look forward: Tax Aware Investing

Let’s now focus our attention on the long-term. Here are some examples of tax aware investing.

  • Tax Loss (and Profit) Harvesting – One way to reduce your taxable income directly is to recognize capital loss and sell investments that have lost their value. Although it isn’t intuitive, capital gains may be possible in years with a lower marginal rate. It is possible to explore additional gains that you can make towards the end of each year without having to trigger the next marginal tax bracket.
  • Asset Location – While nearly all financial professionals are familiar with asset allocation, very few offer advice about asset location. Asset location involves determining when you will need money to finance your goals and then allocating your investments among taxable, tax deferred, or tax-free investments. Consider the following decisions: Traditional IRA vs. Roth IRA vs. taxable annuity vs. tax-deferred annuity, or possibly life insurance.
  • Tax Diversification – W-2 employees often have their majority of wealth in a company sponsored 401(k). Due to the requirement minimum distribution (“RMD”) rules, which mandate that you take taxable withdrawals after you reach a certain age, this can lead to a higher marginal rate of tax in retirement.
  • Higher balances will require you to make taxable withdrawals. Consider filling your marginal tax brackets by making smaller Roth IRA conversions in the future. These amounts will be subject to taxes, but the balance will continue to grow and not be subject to any mandatory RMDs.

A healthy financial plan that is goals-based and includes tax planning before tax preparation can have a significant impact on your long-term wealth after taxes. It is important to work with professionals or teams that are able to combine tax planning, investment and tax planning.

Converting from a traditional IRA into a Roth IRA can be taxable. Roth IRAs allow for tax-free withdrawals of taxable contributions. A Roth IRA must have been in existence for at least five years. The distribution must occur after age 59 1/2, death, disability or first home purchase. State taxes may apply to Roth IRA distributions, depending on the state law where you live.

Tax aware investing saves taxesTax Aware Investing is not just for the seasoned tax professional or financial planner. It is something that can be done on your own, and with a little bit of research, you can be well on your way to developing a tax-savvy financial plan that will help you reach your financial goals.

Remember, it is not enough just to know what you’re doing is right. You must keep your plan flexible as life and financial circumstances change. Whether you are working to build assets or protect against future inflation, using tax-savvy investing to your advantage can help you get closer to meeting your financial goals.

It is important to remember that tax planning is only part of the equation. Although it can help you save money now, it is even more important to create a long-term financial plan that will help you achieve your goals in the future.

The best investment strategies are based around a long-term financial plan that takes into account taxes, inflation, and any potential retirement or life changes. Any investment strategy, such as investing to avoid taxes,  will not work unless it is combined with a long-term financial plan that is flexible enough to keep up with life’s changes.


Latest posts by Gust Lenglet (see all)
Thank you for sharing.

2 responses to “Tax Aware Investing”

  1. Cynthia K. says:

    Wow! I was just browsing and came upon your site. I must say I’m totally impressed. All of your articles, great tax tips, and the new one called tax loopholes, must have taken you a long time to work on them. You go to great lengths to inform the public on this relevant and timely information. I just wanted to let you know how much I appreciate what you’re doing and hope you continue. The tax loophole article made me so frustrated with some of those self-serving politicians as you must have been when you wrote it. An $18 billion annual loophole, and they couldn’t get the votes to close it. I agree with your comment about wealthy PACs getting politicians to vote their way. I guess money talks really loud. Keep up the great work.

    • Gust Lenglet says:

      Thanks for your kind words Cynthia. Yes, it’s a lot of work maintaining the site, but I feel it’s worth it. If I can help someone save some money on taxes and if folks like you read and comment, I enjoy doing it. That tax loophole article had me angry as well as frustrated. I read a few other articles where the Inflation Reduction Act passed the Senate with the closing of the loophole taken out. They keep pushing the purchase of electric vehicles with no improvement of the current power grid. We’re heading for another big day of reckoning! Thanks for commenting and we would appreciate sharing of our site and articles very much.

Your comments are much appreciated...