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Keep More of Your Wealth

There is an old piece of tax wisdom that says, “It’s not what you earn, it’s what you keep.” And that has never been more true than today.

Currently, income taxes have risen to a top rate of 39.6%. There are also a few additional taxes for high wage earners based on the recent healthcare legislation. And for many, state taxes push the combined rate above 50%!

That is a huge loss of wealth, and it is even more concerning if you believe that market returns may be more moderate for the foreseeable future than they have been in recent years. The challenge of protecting and building wealth in this environment makes tax-efficient investing critical.

In a moment, we will discuss techniques for mitigating taxes in your investment accounts. But first, consider the impact lower taxes have on your long-term wealth. Suppose you have money invested in your brokerage account, and you need to take funds out. For this example, this fund withdrawal will create a $200,000 taxable gain. Here are the two extremes of what your tax bill could be if you are in the top tax brackets:

  1. If all of the $200,000 in gains were short-term, your federal tax bill would be a whopping $86,800.
  2. If all of the $200,000 in gains were long-term, your federal tax bill would be nearly cut in half at $47,600.

That is a VERY simplified scenario, but the message should be clear: The money you save in taxes can make a significant impact on your long-term wealth. At FPC, we consider the following tax-management strategies to be essential:

  • Asset location. The way your investments are distributed across your taxable and non-taxable accounts can have a significant impact on your overall tax liabilities. A simple example would be placing tax-exempt municipal bonds into a taxable account—those bonds, after all, don’t need additional tax protection. And that decision, in turn, might leave room in your IRA for investments that are not tax-exempt and need to be shielded from taxes. A study by Vanguard has found that asset location can increase your net returns by up to 0.75%.
  • Tax-loss harvesting. The federal tax code allows investors to use realized investment losses to offset the taxes on their winning investments. Let us say you realize a $10,000 capital gain on one investment. By selling investments that have lost that same amount, you have the ability to neutralize that tax liability. Tax-loss harvesting must be done thoughtfully, of course. Some investments require a longer time horizon than others to achieve success, and you would not want to sell them prematurel
  • Disciplined investing. Selling an investment before a year triggers short-term capital gains taxes—which can be as high as 43.4%. However, investments held for more than a year are subject to the long-term rate–which can be no higher than 23.8%. We believe that holding most investments for long periods is the key to tapping the market’s potential for capital appreciation. The tax benefits of doing so make this strategy even more compelling.

Like water, money is a resource. Plugging the “leaks,” including unnecessary taxes, can make a significant impact on your wealth and well-being.

Bijan Golkar is a Certified Financial Planner™ and licensed tax preparer with FPC Investment Advisory Inc. in the San Francisco Bay Area.

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