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Basic Rules to Make Your Portfolio More Tax Efficient

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If you’re a do it yourself investor, you probably know a thing or two about stock selection but might not have given much thought to the tax implications of your investment actions. You should never pick investment products with the tax advantage as your primary reason. A quality investment product trumps tax advantages any day of the week but part of making money as an investor is to position it in the best way possible to keep the IRS’ hands off of it.

If all of your investment capital is kept in a single brokerage account there are likely better ways to make your money work harder for you. You may want to consider setting up a Roth IRA but let’s assume that you set up a traditional IRA that allows you to forego paying taxes on that money until you retire. Knowing that, we want to keep our realized gainers in or IRA and our unrealized gainers in our brokerage account. Here’s how to use it to keep more money out of the hands of Uncle Sam and in your account.

Realized Gainers

If you loaned a buddy $5 and told him that he had to pay you back $10, you would have a realized gain of $5 when he finally paid you. If the IRS found out, you would owe taxes on that $5. In the investing world, you can have realized gains by selling your investment for a profit or by earning dividends on your stocks and bonds.

You want your realized gainers in your IRA because you don’t have to pay taxes on those dividends or sales until you start drawing money from the account. This allows those realized gains to compound more rapidly because the IRS didn’t take any of the proceeds in the year that you earned them.

Not only will you keep your dividend paying stocks in your IRA, any fixed income investments like bonds and bond ETFs should have as their home, your IRA—most of the time. A rule of thumb among financial advisers is never to put a tax shelter inside of a tax shelter so your traditional IRA should not hold municipal bonds in most cases.

As Motley Fool says, IRAs and dividend stocks are like chocolate and peanut butter so as a general rule, keep any investment that is paying out a dividend in your IRA.

Unrealized Gainers

What if you loaned your buddy $5 under the same terms but he hasn’t paid you back yet? In the simplest sense, your $5 is an unrealized gain. The IRS can’t tax you on it because you haven’t pocketed the gains. You know that McDonalds stock that you bought that you plan to hold for 20 years? Put that in your brokerage account because as long as your gains are unrealized, you don’t have to pay taxes on the rise in value until you sell the stock for a profit. (Although you will have to pay taxes on the dividends that your McDonalds stock pays you)

I’m Not Warren Buffett

When Warren Buffett buys stock, he claims that his time frame is forever but what if you’re the type that picks stocks to hold for a much smaller time frame? If you pick the right high growth stocks, they will produce more income than the dividend payers. As Morningstar says, placing these stocks in your IRA may be a better bet.

Finally

Constructing a truly tax efficient portfolio is a difficult task for retail investors. Some financial advisers will show you how to position your holdings for maximum efficiency and only charge you a one time fee. The small fee for professional advice will easily pay you back many times over as your money compounds. There’s no reason you can’t get started on your own. If you remember the few general rules above, this will give you a good start.

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3 Responses to “Basic Rules to Make Your Portfolio More Tax Efficient”

  1. mannymacho says:

    If dividends are taxed at a lower rate, why do you want to keep them in an IRA? Isn’t that about the same thing as putting a tax shelter inside a tax shelter?

    • govenar says:

      The IRA has some advantage due to compounding; each year, you can re-invest the full amount of the dividends, rather than just the amount left over after taxes. It probably only makes since for Roth IRA though (no tax when you withdraw), not Traditional IRA where you’d have to pay ordinary income tax rates on everything instead of the 15% the dividends would’ve been taxed it otherwise.

  2. Dividends, Interest and Capital Gains/Losses. Interest income belongs in the IRA since it is taxed at regular income rates. Dividends and Capital Gains/Losses belong in taxable accounts since they are taxed (at least as of now) at 15%. It’s that simple.


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