Are Your Investments Tax Aware?
Most investors spend a lot of time asking one question: What return did I earn?
It’s not a bad question, just incomplete. A better question might be:
How much of that return did I actually get to keep?
Because investment returns don’t happen in a vacuum. Every dividend, every interest payment, every capital gain, and every trade has the potential to create taxes. If your investments aren’t working alongside your tax return, you may be paying more taxes than necessary based on your individual circumstances.
That’s one of the reasons we review our clients’ investment strategies every year, not because we’re trying to predict the market, but because we’re trying to help reduce unnecessary friction.
The Return You See Isn’t Always the Return You Receive
Imagine two investments.
One pays 5%. The other pays 4%.
Which one is better?
Most people immediately choose the 5%.
But what if the 5% investment creates ordinary taxable income while the 4% investment receives more favorable tax treatment? Depending on your tax bracket, you may actually get to keep more of the 4% investment.
Let's take a look at a hypothetical example: $100,000 invested. The first investment pays 5%, taxed as ordinary income. The second investment pays 4% in qualified dividends being taxed at the 15% preferential rate.
| Marginal Federal Tax Bracket | 5% Ordinary Income: Tax You Owe | 5% Ordinary Income: What You Keep | 4% Qualified Dividend: What You Owe | 4% Qualified Dividend: What You Keep | Who Wins After Tax? |
|---|---|---|---|---|---|
| 22% | $1,100 | $3,900 | $600 | $3,400 | 5% Investment (by $500) |
| 24% | $1,200 | $3,800 | $600 | $3,400 | 5% Investment (by $400) |
| 32% | $1,600 | $3,400 | $600 | $3,400 | Dead Even |
| 35% | $1,750 | $3,250 | $600 | $3,400 | 4% Investment (by $150) |
This concept is called Tax-Equivalent Yield.
In other words, not all investment income is created equal. Sometimes an investment with the lower stated yield actually provides the higher after-tax return.
That decision has nothing to do with predicting markets. It has everything to do with understanding how taxes affect your investments.
After-Tax Returns Matter More Than Headline Returns
One possible issue investors may encounter is focusing only on investment performance.
We’d rather focus on after-tax performance. Those aren’t always the same thing.
A strategy that earns 8% but generates higher tax liabilities may, in certain circumstances, leave an investor with a lower after-tax return than a strategy earning 7.5% with more favorable tax treatment. That’s one reason we don’t believe investment management and tax planning should happen in separate conversations. They’re solving the same problem.
Not Every Dividend Is Your Friend
Dividend investing has earned a great reputation over the years. In many cases, we agree. But not every dividend belongs in every account. Some investments distribute income that’s taxed at your ordinary income tax rate rather than the lower qualified dividend rates.
That difference can be substantial.
When possible, we’d rather own tax-efficient investments in taxable accounts while reserving retirement accounts for investments that create less favorable tax consequences. The investment itself isn’t necessarily the problem. It may simply be sitting in the wrong place.
Why We Aren’t Big Fans of Actively Managed Mutual Funds
This one surprises people. It isn’t that actively managed mutual funds are bad investments. Many are managed by talented professionals whom we admire. The challenge is that investors can sometimes receive taxable capital gain distributions even if they never sold a single share.
Think about that.
Someone else makes trading decisions inside the fund, but you (and others invested in the fund) could encounter unfavorable tax consequences. Whenever practical, we prefer investments that give us greater control over when taxable gains are realized. Control matters a lot when taxes are involved.
It’s Not Just What You Own. It’s Where You Own It.
One of the biggest misconceptions in investing is that every investment belongs in every account.
We don’t see it that way.
Sometimes the exact same investment can produce a different after-tax outcome depending on whether it’s held in a taxable brokerage account or inside an IRA. That’s why we spend so much time thinking about asset location—deciding not only what to own, but where to own it.
For example, we often prefer to hold investments that generate less tax-friendly income inside retirement accounts whenever practical. That may include:
- Investments paying ordinary (non-qualified) dividends.
- Certain precious metals investments, such as gold and silver, which may receive less favorable tax treatment when sold.
None of these investments are inherently bad. In fact, each can serve an important purpose within the right portfolio. But if a similar investment objective can potentially be achieved while improving tax efficiency through asset location, it may be worthwhile to evaluate whether a different account placement is appropriate. Sometimes the most valuable investment decision isn’t buying something different. It’s putting the right investment in the right account.
Your CPA and Your Financial Advisor Shouldn’t Be Playing Different Games
Your CPA’s job is to accurately report what already happened. Our job is to help influence what happens next. Those are two very different jobs.
- If your CPA doesn’t know what investments you’re buying, they can’t help optimize them.
- If your financial advisor doesn’t understand your tax situation, they may unintentionally create taxes that could have been avoided.
Investment management and tax planning can often be more effective when considered together. That’s why we coordinate with your CPA every year. Not because we’re trying to outsmart the market, but because we’re trying to stop giving away dollars that never needed to leave your pocket in the first place.
The Bottom Line
We don’t review your investment strategy each year because we enjoy making changes. Quite the opposite.
If nothing needs to change, we’d much rather leave your portfolio alone. But ignoring taxes simply because your investments are performing well is like celebrating a raise while forgetting to look at your paycheck. Investment returns matter, but keeping more of the money you make matters even more. The market decides what you earn.
Good planning helps determine how much you keep.
Any opinions are those of Forge Financial and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
This includes a hypothetical situation and not indicative of any specific situations or client. It is presented only as an example and not intended as investment advice. Investing involves risk and there is no assurance that any investment strategy will be successful.
Raymond James and its advisors do not offer tax advice. You should discuss any tax matters with the appropriate professional.
