Avoid Surprise Taxes by Redistributing Your Investment Portfolio — Experts Share How

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Investment gains are great when they roll in, but less so once you have to pay taxes on them. Investment losses are never great — yet you might still have to pay taxes on them, which can come as a shock to taxpayers who haven’t planned ahead of time. You might also face a surprise tax for selling assets or receiving income in a brokerage account.

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The best way to avoid surprise income taxes on investments is to review your portfolio ahead of time and consult with financial experts about the best tax strategies. In fact, the tax impact of investments is a major consideration with many financial advisors.

“I definitely take [taxes] into consideration when I’m designing portfolios for clients,” JoAnn May, a certified financial planner at Illinois-based Forest Asset Management, told CNBC. “I always keep the taxability of assets in mind when strategizing where things are going to go.”

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She and others recommend putting different assets into different types of accounts to minimize your tax hit. For example, because bonds distribute income but have slow growth, they might be best suited for tax-deferred accounts such as 401(k) plans. On the other hand, investments that are likely to appreciate in value are better off in tax-free accounts like a Roth IRA.

Investors with large portfolios of mutual, index and exchange-traded funds can avoid unpleasant tax surprises by holding their investments in tax-sheltered accounts such as IRAs and 401(k)s, according to Jeff Sommer, a financial writer for The New York Times.

“What all of these tax-sheltered accounts generally do very well is insulate you from taxes on dividends, interest income and capital gains, as long as you hold your investments inside them,” Sommer wrote in a recent column. “So if you have a choice, try to emphasize tax-efficient funds in taxable accounts.

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ETFs offer more tax efficiency than traditional mutual funds, he added, while index funds are typically more tax efficient than actively managed funds. Bond funds and high-dividend stock funds are usually less tax efficient than simple stock index funds.

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If you have a large enough bond portfolio, you might have to put some assets in a brokerage account, May told CNBC. Depending on your income, however, she suggests considering municipal bonds, which typically avoid federal taxes and possibly state and local taxes on interest. 

Other assets to avoid in a brokerage account are real estate investment trusts because they must distribute 90% of taxable income to shareholders, Mike Piper, a St. Louis-based CPA, told CNBC.

“If you have to have [funds] in taxable accounts, you want to make sure it’s generally something with low turnover,” Piper said.

All-in-one funds, which aim to create an entire portfolio, are also better suited for tax-deferred or tax-free accounts. Because all-in-one funds contain different types of assets, you can’t separate individual assets into different accounts.

If you can’t figure out a way to maximize tax efficiency across all of your investments, don’t be discouraged. It’s impossible for most investors, so the best strategy is to figure out which specific assets have the best chance of lowering your tax bill.

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“Relatively few Americans have large investments in both taxable and tax-sheltered accounts,” Vanguard tax expert Joel Dickson told the NYT, adding that whenever possible, try to emphasize tax-sheltered accounts.

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About the Author

Vance Cariaga is a London-based writer, editor and journalist who previously held staff positions at Investor’s Business Daily, The Charlotte Business Journal and The Charlotte Observer. His work also appeared in Charlotte Magazine, Street & Smith’s Sports Business Journal and Business North Carolina magazine. He holds a B.A. in English from Appalachian State University and studied journalism at the University of South Carolina. His reporting earned awards from the North Carolina Press Association, the Green Eyeshade Awards and AlterNet. In addition to journalism, he has worked in banking, accounting and restaurant management. A native of North Carolina who also writes fiction, Vance’s short story, “Saint Christopher,” placed second in the 2019 Writer’s Digest Short Short Story Competition. Two of his short stories appear in With One Eye on the Cows, an anthology published by Ad Hoc Fiction in 2019. His debut novel, Voodoo Hideaway, was published in 2021 by Atmosphere Press.
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