Tax-Efficient Investing

When investors earn money from their investments, they must pay taxes on that interest. Interest from investments and dividend payments are taxed at the same rate as income. If a financial professional fails to consider the tax implications of their recommended investments, their clients may face unnecessarily large tax bills.

Tax-efficient investing ensures that investors do not have to pay more tax than necessary. Portfolios may allow interest to grow tax-deferred, and high-net-worth individuals often have a special focus on tax-saving investments. The IRS imposes taxes on a sliding scale, so the higher the investor’s income, the more tax they are required to pay.

Why Does Tax-Smart Investing Matter?

Brokers and financial advisors should consider tax implications when building a diversified portfolio. “Diversification” does not exclusively refer to ensuring a diverse mix of stocks and bonds. Financial professionals should also factor in tax implications when calculating the risks posed by a given investment.

Firms Offering Tax Advice

Many brokerage firms are also registered as advisory firms that can suggest tax strategies. Make sure you understand your financial professional’s qualifications and licenses. Not every stockbroker is also registered as a financial advisor, and a stockbroker registration alone does not qualify an individual to offer tax advice.

Investment Products that Can Result in Unexpected Taxes

Financial professionals should have frank discussions with their clients about the potential tax implications of the following investments.

Mutual Funds

Mutual fund investors rely on the fund managers to make tax-conscious decisions. When a manager sells one of the securities in the fund’s underlying portfolio, it could trigger a capital gains tax. The manager might re-invest the money from that sale, but the investor will still owe capital gains tax, despite having not yet received any interest payments or dividends from the mutual fund.

Managers should not sell any underlying shares before one year, because the IRS imposes a higher tax rate on short-term capital gains.

Actively Managed Funds

Investors are paying actively managed fund managers to make savvy decisions when they execute trades. These managers should avoid executing too many trades that would result in unnecessary capital gains taxes.

Real Estate Investment Trusts (REITs)

REITs may appeal to investors because of their relatively high dividend payouts. But investors should be aware that these are non-qualified dividends, which come with higher tax rates than qualified dividends.

Syndicated Conservation Easements

Conservation easements are meant to reduce tax burdens for high-income investors with a purchase that limits the development of a plot of land and provides a tax deduction in return. However, many syndicated conservation easements have been revealed as abusive tax shelters. In these cases, appraisers over-inflate the value of an easement property so that investors can take a bigger deduction. Investors may purchase these easements without understanding the potential for a hefty IRA penalty.

1035 Exchanges

These types of exchanges are designed to avoid tax penalties when exchanging a life insurance policy for a new policy or a new annuity. Investors should be aware, however, that these exchanges do not apply to taxable gains, such as a loan taken out under the old policy. Any such gains would be subject to taxes following a 1035 exchange.

Potentially Tax-Friendly Investments  

Tax-aware investment strategies may include the following investment products.

Exchange-Traded Funds

Like mutual funds, Exchange-Traded Funds (ETFs) feature an underlying portfolio of investments. Unlike mutual funds, ETF shares do not pay cash when investors receive shares. Instead, they redeem shares using “in-kind” transactions, meaning they redeem ETF shares for securities.

ETFs typically offer the most tax advantages to investors who own them for a year or more.

Investors note: Non-traditional ETFs have special risks that might negate any supposed tax benefits.

Municipal Bonds

Investors do not have to pay federal taxes on interest generated by municipal bonds. Many municipal bonds are also not subject to state or local taxes.

Master Limited Partnerships (MLPs)

If investors remain invested in their MLPs for a sufficient amount of time, they only have to pay capital gains taxes once they sell their shares. (Investors should know that MLPs are not low-risk investments and investors may want to sell their shares early for a variety of reasons.)

I Bonds and Series EE Bonds

These bonds may not come with any taxes if the investor puts the proceeds toward education. I Bonds and Series EE Bonds are also not subject to state or local income tax. 

Tax Advantages of Retirement Savings Accounts

Tax-efficient investing strategies often involve the following types of retirement savings accounts.  

401(k)s

Employers may offer 401(k)s, which are retirement savings accounts that invest their employee contributions. Employees can choose how much to contribute, and employers often match their contributions. These contributions are not taxed, which means that investors will pay taxes in the future when they make withdrawals. In the meantime, keeping more money invested means the account will be able to generate more interest.  

Traditional Independent Retirement Accounts (IRAs)

Investors deposit pre-tax income into IRAs, just as they do in 401(k)s. The only difference is the IRA is independent of an employer. The money in the IRA account either goes into investments or an interest-bearing savings account. Investors pay taxes when they make a withdrawal. If an employee rolls over their 401(k) into a rollover IRA, investors pay taxes on the withdrawals, just as they would with a traditional IRA.

Roth IRAs

For these investment savings accounts, investors deposit income after taxes. This money can be withdrawn tax-free in retirement, once the investor is at least 59 ½ years old and has had the account for at least five years. Investors can also withdraw money from a Roth IRA tax-free as long as they only withdraw from the portion they contributed and do not touch any of the account’s investment earnings.

Non-Qualified Annuities

Investors should know that contributions to these types of policies are not tax-deductible, unlike contributions to 401(k)s. These investments do, however, offer income payments during retirement as well as tax-deferred growth. Investors who buy these Investors pay taxes when they withdraw money.

Variable annuities and VULs may fall under this category, but investors should be aware of the many drawbacks associated with these types of investment vehicles, including their complexity and potentially high fees.

Single-Premium Immediate Annuities (SPIAs)

SPIAs are an insurance product with supposed tax advantages that may not last. Investors may turn to SPIAs for the tax-free monthly payments, which the IRS classifies as a return of principal. Once the principal runs out, the payments from the SPIA will be taxable, unless the SPIA was funded with post-tax money.

Tax-Efficient Investing Strategies

Investing strategies should take into account your long-term goals, liquidity needs, and tax bracket.

Tax-Loss Harvesting

Financial losses are part of investing, but the IRS allows investors to recoup a portion using tax-loss harvesting. Selling poorly performing securities results in losses, but investors can deduct those losses from their taxable income, reducing their tax burden.

Tax-Efficient Investing for High Earners

Wealthy investors may be especially wary of the tax implications of their investments. The more money they have invested, the more taxes they will owe on sizable withdrawals. The IRS also imposes higher tax rates on higher incomes.

Certain investments are only offered to accredited (i.e., wealthy) investors. Investors may want these products because of the reduced tax liability – for instance, a Direct Private Placement investor benefits from the DPP’s tax deductions. Since DPPs are private placements, however, they come with higher risk, and investors may find out too late that their broker failed to disclose all the associated risks.

Regulation Best Interest and Tax-Aware Investing

Regulation Best Interest (Reg I) requires that brokers take into account their investors’ tax statuses and financial goals when recommending investments. Brokers who fail to do so may face a customer dispute that ends up in FINRA arbitration.

Broker Misconduct and Tax-Advantaged Investments

Brokers and investment advisors are held to the highest fiduciary standard when providing advice related to 401(k)s. Unfortunately, in many cases, brokers have advised their clients to liquidate their 401(k)s in order to purchase risky securities that come with steep commissions for the brokers.

Brokerage firms may face steep fines if they fail to catch this type of misconduct. Independent Financial Group consented to a $200,000 fine following allegations that it failed to supervise a representative who recommended that retired investors liquidate their 401(k)s in order to invest in risky non-traded REITs and structured notes, among other allegations.

Misrepresentation of Tax-Deferred Investment Vehicles

Brokers may highlight the tax advantages of investment vehicles while neglecting to mention their potential drawbacks. Misrepresentation or omission of material facts violates FINRA Rule 2020, and is one of the most common examples of investment fraud. 

Certain products, like Variable Universal Life Insurances (VULs) and Variable Annuities, can tempt investors with their promises of tax-deferred growth. Many investors find out the hard way that these annuities can have underlying investments that hurt their overall efficacy. Brokers who do not have their customers’ best interests in mind may recommend these investments in order to earn sizable commissions.

Selling Too Soon

Investments bought and sold in quick succession can result in unexpected tax consequences. Brokers may recommend selling an investment too quickly in order to re-invest the money and collect more commissions. This is an example of an unsuitable transaction that could result in an investment fraud case.

For instance, if an investor sells an ETF and then buys a similar ETF within 30 days, they may not be able to deduct the capital losses from their taxes. Investors must also hold dividend-paying stock for 60 days (or 90 days for preferred stock dividends) in order to qualify for a lower tax rate.

Capital Gains Taxes

Selling a stock results in a capital gains tax, which is generally lower than income tax. But stocks that are sold too soon (i.e., in less than a year after purchase) are not treated as capital gains and are therefore taxed at a higher rate. Tax-efficient strategies should take into account this easily avoidable investing mistake.

How Can a Securities Lawyer Help Me?

Did your broker communicate to your broker that you wanted tax-friendly investments, only to find that your investment came with a surprise tax bill? You may be able to recoup losses by speaking with an investment fraud lawyer.

It can be difficult to get money back from bad investments. Investors often have to demonstrate that they lost money as a result of broker misconduct and a clear violation of securities rules and regulations. Investment contracts often require investors to go through a process called FINRA arbitration rather than suing in civil court. FINRA arbitration is a niche legal topic, and our securities attorneys are experts.

The securities lawyers at Kurta Law provide free case evaluations and only collect a fee once we win your case. Call (877) 600-0098 or email info@kurtalawfirm.com today.