Much has been made of the fact that Mitt Romney pays a much
lower tax rate than many middle-class Americans. In part, this is
because Romney derives more of his earnings from investments than
the typical American, and capital gains are taxed at a lower rate
than wages and many other forms of interest.
Curiously, while people may resent Romney for having more money
yet paying a lower tax rate than they do, many of those same people
probably envy him as well -- if not for his wealth, then probably
for that low tax rate. The fact is, people go to great lengths to
try to minimize their tax liabilities -- so much so that these
strategies are sometimes counterproductive.
Here are three concepts to keep in mind when managing the tax
consequences of your
investments
.
1. Don't avoid taking gains just to avoid the tax
liability
One advantage that stocks and other investments have is that you
don't incur a tax liability until you realize the gain -- that is,
until you sell. Unfortunately, some people are so averse to paying
taxes that they will hold off on selling a stock just so they can
delay realizing the gain. This is often a mistake.
Remember, the tax rate applies just to the amount of your gain
on the stock, while market fluctuations will affect the entire
value of that stock. In other words, you typically have more to
lose from investment risk than from the tax liability. It may make
sense to hold off on selling for a couple weeks if it is very near
the end of the year, but don't push you luck by waiting too long.
2. Be careful that harvesting losses doesn't mean missing
opportunities
A favorite tax strategy of many investors is harvesting losses near
the end of the year. This means selling stocks that are down, so
you can use those losses to offset your gains. The problem is that
IRS rules require you to wait 30 days before you repurchase the
stock, or else you cannot claim the loss. So, you have to be
careful that you don't miss a rebound in the stock while you are
waiting. Think carefully about the size of the tax liability you'll
be avoiding compared to the potential opportunity cost of being out
of the stock at the wrong time.
3. Consider tax status when setting your allocation
across portfolios
Some financial planners recommend that you concentrate
income-producing securities in tax-deferred portfolios, such as an
IRA or 401(k) plan, while concentrating stocks in an after-tax
portfolio, if you have one. This is because the tax rate on income
is typically higher than the tax on capital gains, so you will
benefit more from earning interest in a tax-deferred portfolio.
However, with bond yields and savings account rates so low, this
strategy will be less rewarding than in a higher interest rate
environment. Also,
emergency funds
and any other money you might need to get at in a hurry should not
be put in a tax-deferred portfolio.
Remember, tax liabilities only amount to a portion of your
investment gains. Therefore, by definition those investment gains
will always be larger than your tax liability from investing, so
investment considerations should by the primary factor in your
decision-making.