When it comes to making investing decisions, don’t let tax considerations solely dictate your investment strategy. However, taxes are an important part of investing and educating yourself on the basics can benefit you, especially in retirement.

So how do you determine if, how and when your assets will be taxed? Will they be subject to capital gains taxes or ordinary income taxes? There are a number of variables for investors to consider and Fisher Investments has valuable suggestions on how to help create and adhere to a tax-efficient strategy that aligns with your long-term financial goals

  • Investment Tax Rate
  • Lowering Your Taxes
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Ordinary Income Tax and Capital Gains Tax: Which Tax Rate Applies to Me?

For certain assets, capital gains may be taxed differently, according to whether you held the asset for more than a year (long-term capital gains) or not (short-term capital gains). Short-term capital gains are taxed at your ordinary income rate, while a long-term gain is often taxed at a lower long-term capital gains rate.1 

In most cases, ordinary income tax rates are higher than long term capital gains rates. You should discuss your individual tax circumstances with a Certified Public Accountant (CPA) or other tax adviser before embarking on an investment strategy.

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Taxpayer Relief: Ways to Lower Your Tax Bill

Each tax year, taxpayers have the opportunity to lower their tax bill through a number of tax-efficient strategies. In a taxable account, you may be able to offset some capital gains with capital losses by selling positions which have declined in value relative to their original purchase price.

We refer to this practice as “tax-loss harvesting.” You might also consider contributing to tax-deferred accounts, which may help reduce your current taxable income and save more for the future. Before determining what options to use as part of executing your tax-efficient strategy, it may be best to discuss it with a tax advisor to get advice specific to your situation. 

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Ordinary Income Tax: The Basics

Income tax is collected on many different forms of income. Taxable income includes, but is not limited to, salaries, commissions, rental income and short-term investment income. For retirees, it may also include social security income, pension income, and income from annuities. The Internal Revenue Service (IRS) is responsible for collecting taxes and enforcing the income tax laws in the US.

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Tax Rates and Retirement

The US imposes a progressive, tiered tax system, meaning those who earn more pay taxes at higher effective rates than those who earn less. As you near retirement, it is important to consider whether your taxes will be higher or lower than they are now. Your tax bill will depend on how you derive your retirement income and the tax treatment of that income. Fisher Investments can help determine how much money you can spend in retirement and a Certified Public Accountant (CPA) can help you determine the tax implications of withdrawing the funds.

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Capital Gains Tax and Mutual Funds

Investors who sell assets at a profit within a taxable account or outside a retirement account may be responsible for paying capital gains tax on the difference between the purchase price and the sale price. If you are a mutual fund shareholder, you could also face a capital gains tax bill even if you haven't sold any of your shares. This can happen even if the fund has declined in value.

  • The law requires mutual funds to pass realized gains (meaning profits locked in through a sale, in this case from the mutual fund’s portfolio manager) through to fund shareholders.

  • You can even wind up with a big tax bill if there is high trading activity in the fund, or if many other investors redeem fund shares—even if you took no action.

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Mutual Funds vs. Separately Managed Accounts

While mutual funds may have diversification benefits for some investors, if you’re looking for more flexibility and control, you should consider investing in individual securities. By investing in individual securities rather than mutual funds, you get to choose which securities to sell and whether to realize short-term or long-term gains or losses.

Fisher Investments’ private client portfolios are separately managed accounts with an emphasis on owning individual securities (and, occasionally, exchange-traded funds). With individual shares in non-retirement accounts, we are able to manage clients’ individual potential tax exposure via tax-loss harvesting based on clients’ own unique circumstances, something a mutual fund owner simply cannot do.

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Tax-Advantaged Accounts and Taxpayer Relief

You may have saved some money in a tax-deferred account, such as a traditional 401(k) or individual retirement account (IRA). Contributing to these accounts annually may help reduce your current tax burden and help save more for the future.2

When you withdraw money from tax-deferred accounts, you will pay ordinary income taxes on that income, which may likely be higher than the taxes you would pay on long-term capital gains.3 Further, assets in tax deferred accounts are subject to required minimum distributions beginning at age 73 (under current law)

This means you will have to take withdrawals from these accounts and pay taxes on those withdrawals, even if you don’t need the money. Finally, failing to take the minimum withdrawals from these accounts as prescribed can subject you to additional tax penalties.

Alternatives to Tax-Deferred Accounts

An alternative to a tax-deferred account is a tax-exempt account, such as a Roth IRA or a retirement plan with Roth contributions. In these accounts, you pay taxes on the money before contributing, and you normally will not owe income taxes on withdrawals. Unlike traditional IRAs and Roth 401(k) plans, there are no RMDs for Roth IRAs during the account owner’s lifetime.

With tax-exempt accounts, another potential tax benefit is you won’t pay capital gains taxes on your investment gains. That means you won’t have to see income taxes on your withdrawals or capital gains taxes on short-term capital gains, short-term losses, long-term capital gains or long-term losses.

The option that will benefit you most depends on your current tax rate and your tax rate in retirement, so it may be best to discuss your options with a tax adviser.

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Tax-Loss Harvesting and the Wash Sale Rule

Capital gains taxes aren’t the most pleasant aspect of investing, but they are usually an indication of successful investing. Said differently, capital gains taxes can be a good problem to have. To reduce some of the tax burden, there are some tax-loss selling tactics you may be able to incorporate into your investing strategy.

  • In a taxable account, you may be able to offset some capital gains with capital losses by selling positions worth less than what they were originally purchased for. We refer to this practice as “tax-loss harvesting.” Just be aware of the “wash sale rule” against buying the same or substantially identical security within 30 days after selling it.

  • The wash sale rule seeks to prevent investors from incurring losses and repurchasing securities immediately after selling them. If you end up incurring a wash sale, you may not be allowed to use the realized tax loss to offset your capital gains. 

For investors, losses are bound to happen, but losses alone shouldn’t necessarily change your outlook for an investment. Tax-loss selling to offset your capital gains, however, can be a viable way to help manage your tax bill.

Nothing herein constitutes legal, tax or investment advice. The foregoing constitutes the general views of Fisher Investments and should not be regarded as personalized advice. Please seek the guidance of a CPA when making tax planning decisions. Investing in securities involves a risk of loss.  Past performance is no guarantee of investment returns. Investments in securities involves the risk of loss.

1(https://www.irs.gov/pub/irs-pdf/f1040sd.pdf, n.d)

2(https://www.irs.gov/pub/irs-pdf/p590a.pdf, n.d.)

3(https://www.irs.gov/pub/irs-prior/p590b-2021.pdf, n.d.)

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