Tax-aware investing is not about avoiding taxes at all costs. It is about understanding how investment decisions affect your tax situation—and considering those consequences before taking action.
Many investment portfolios are managed primarily around expected return, risk tolerance, and diversification. Those considerations are essential, but they do not tell the entire story. Two investments with similar pre-tax returns can produce meaningfully different results after taxes.
Tax-aware investing adds another question to the decision-making process:
How much of the return will you actually keep?
For business owners, executives, professionals, retirees, and families with increasingly complex financial lives, taxes can influence everything from portfolio rebalancing to retirement withdrawals. A coordinated strategy can help investors pursue their long-term goals without creating unnecessary tax costs along the way.
A tax-aware investor does not refuse to sell an investment simply because doing so will create a gain.
Holding an inappropriate, concentrated, or excessively risky investment to avoid taxes can create a much larger financial problem.
Similarly, an investment should not be purchased solely because it offers a tax benefit. Municipal bonds, retirement accounts, charitable strategies, and other tax-advantaged tools must still make sense within the investor’s broader financial plan.
The objective is to balance several considerations:
Taxes are one part of the analysis, but they are rarely a part that should be ignored.
Investors generally do not owe capital-gains tax merely because an investment has increased in value. The gain is typically recognized when the investment is sold.
That creates an opportunity to plan the timing of a sale.
Before realizing a significant gain, a tax-aware review may consider:
Capital gains may also contribute to the 3.8% Net Investment Income Tax when a taxpayer’s income exceeds the applicable statutory threshold.
This does not mean that gains should always be postponed. Sometimes realizing a gain is the right decision because the portfolio needs to be rebalanced, a concentrated position presents too much risk, or the proceeds are needed for another goal. Tax-aware investing means evaluating the tax cost alongside the investment rationale rather than discovering the consequences after the sale.
Tax-loss harvesting involves selling an investment that has declined in value so the loss can potentially offset realized capital gains. When losses exceed gains, a limited amount may generally be used against other income, with remaining losses carried forward under applicable tax rules.
However, tax-loss harvesting is not simply a year-end exercise.
Market declines can occur at any time, and waiting until December may mean missing an opportunity. A tax-aware portfolio may be reviewed throughout the year for losses that can be harvested while maintaining the portfolio’s intended investment exposure.
Care is also required because of the wash-sale rules. A loss may be disallowed when substantially identical securities are purchased within 30 days before or after the loss sale. The rule can also apply to purchases in an IRA or Roth IRA and, in certain circumstances, purchases made by a spouse or controlled corporation.
The goal should not be to create losses for their own sake. The goal is to use losses that already exist in the portfolio while keeping the investment strategy aligned with the investor’s objectives.
Many investors hold several different types of accounts:
These accounts do not all receive the same tax treatment. The same investment can therefore produce a different after-tax result depending on where it is held.
For example, investments that regularly generate taxable interest or short-term distributions may sometimes be better suited for a tax-deferred account. Tax-efficient stock investments may be more appropriate in a taxable account, where qualified dividends and long-term appreciation may receive different tax treatment and where losses may potentially be harvested.
Roth accounts may be especially valuable for investments with higher expected long-term growth because qualified Roth IRA distributions can be tax-free when the applicable requirements are met.
This strategy is known as asset location. It is different from asset allocation.
Asset allocation determines how much of the portfolio is invested in stocks, bonds, cash, and other assets.
Asset location determines which accounts should hold those investments.
Asset location should not override liquidity, risk, or portfolio-management needs, but it can improve the tax efficiency of a coordinated portfolio.
A higher stated yield does not necessarily produce a better result.
Suppose an investor is comparing a taxable bond with a municipal bond. Interest from qualifying state or local government obligations may be exempt from federal income tax, although certain bonds can have different treatment and state taxes may still apply.
The appropriate comparison is therefore not simply which bond has the higher yield. The investor should compare the yields after considering their federal and state marginal tax rates, credit quality, duration, liquidity, and other risks.
Treasury interest provides another example. Interest from U.S. Treasury bills, notes, and bonds is generally subject to federal income tax but exempt from state and local income taxes.
A tax-aware analysis examines what the investor is expected to retain after taxes—not merely what appears on the investment’s fact sheet.
Frequent trading can create short-term capital gains, transaction costs, and unexpected tax bills. Even when a trade improves the portfolio, its potential benefit should be compared with the cost of implementing it.
A tax-aware rebalancing strategy may use several methods before selling appreciated investments:
The objective is not to eliminate portfolio changes. It is to make changes intentionally and efficiently.
Retirement income may come from taxable brokerage accounts, traditional retirement accounts, Roth accounts, Social Security, pensions, business interests, real estate, and other sources.
The order in which those assets are used can affect more than the current year’s tax return. It may also influence:
For some retirees, drawing from taxable assets first may be appropriate. For others, taking earlier distributions from tax-deferred accounts or completing partial Roth conversions may reduce projected lifetime taxes.
There is no withdrawal order that is best for everyone. Tax-aware retirement planning evaluates withdrawals over multiple years instead of automatically minimizing the current year’s taxable income.
Executives and professionals receiving restricted stock units, stock options, employee stock purchase plan shares, or other equity compensation face additional tax and investment considerations.
Vesting or exercising an award may produce compensation income before any shares are sold. Selling shares can create a separate capital gain or loss. Holding the shares may increase exposure to a single company that also provides the investor’s salary, benefits, and future compensation.
A coordinated strategy may evaluate:
The lowest immediate tax bill is not necessarily the best result. Continuing to hold a concentrated stock position may postpone taxes, but it can also expose the investor to significant company-specific risk.
Investors who regularly give to charity may be able to coordinate those gifts with their investment strategy.
Rather than selling an appreciated investment and donating the cash, an investor may be able to contribute the investment directly to an eligible charity or donor-advised fund. Depending on the circumstances and applicable tax rules, this may allow the investor to support a charitable goal without personally realizing the embedded capital gain.
Charitable planning may also create an opportunity to remove a concentrated or highly appreciated position from the portfolio.
These strategies require advance planning. Once an investment has been sold, the capital gain has generally already been realized. Tax-aware investing considers charitable intent before transactions occur.
Tax-aware investing does not mean:
A decision can be tax-efficient and still be a poor investment decision. It can also be appropriate to pay taxes when doing so supports diversification, liquidity, retirement income, or another important objective.
Consider an investor who owns a large position in one company’s stock.
Selling the entire position immediately could create a substantial capital gain. Holding the entire position indefinitely could leave the investor exposed to unnecessary concentration risk.
A tax-aware strategy might instead consider:
The appropriate recommendation depends on the investor’s goals, income, other assets, risk tolerance, and tax circumstances. Tax-aware investing does not provide one automatic answer. It provides a better decision-making framework.
Investment decisions do not occur in isolation.
A portfolio sale can affect estimated taxes. A Roth conversion can change the amount of investment income exposed to higher tax rates. A business sale can create new liquidity, concentration, estate-planning, and charitable decisions. Retirement withdrawals can influence both current taxes and future required distributions.
Tax-aware investing brings these issues into the same conversation.
At Foothills Investments, investment recommendations are evaluated within the context of each client’s broader financial life. That includes the client’s goals, portfolio, retirement strategy, cash-flow needs, risk tolerance, and potential tax consequences.
The purpose is not simply to minimize taxes. It is to help clients make informed decisions designed to improve what they keep, reduce avoidable surprises, and support their long-term financial objectives.
Your portfolio should reflect more than a collection of investments. It should support your financial plan, retirement goals, tax circumstances, and the decisions you expect to face in the years ahead.
Schedule a discovery meeting with Foothills Investments to discuss how a coordinated, tax-aware investment strategy may fit into your financial plan.
This material is provided for general educational purposes only and should not be considered individualized investment, tax, accounting, or legal advice. Tax laws are complex and subject to change. Consult the appropriate professionals regarding your individual circumstances.
Foothills Investments, LLC is a Colorado-registered investment adviser. Registration does not imply a particular level of skill or training. Investing involves risk, including the possible loss of principal. Past performance does not guarantee future results.
Foothills Accountants, LLC and Foothills Investments, LLC are separate legal entities under common ownership. Investment advisory services and tax-preparation or accounting services are provided under separate engagement agreements and may involve separate fees. Clients of Foothills Investments are not required to engage Foothills Accountants and may work with any tax professional of their choosing.
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Foothills Investments, L.L.C. is a Colorado-registered investment adviser. Registration does not imply a certain level of skill or training. Advisory services are offered only where Foothills Investments and its investment adviser representatives are appropriately registered or exempt from registration. Investing involves risk, including the possible loss of principal. Past performance does not guarantee future results.
Information on this website is provided for general informational and educational purposes and should not be considered individualized investment, tax, legal, accounting, or insurance advice.
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