Markets soared to record highs last month, continuing the rally that started in 2023. The S&P 500 gained 10.2%, the DJIA, 5.6%, and the NASDAQ, 9.1% in the first quarter of 2024. More than half of the stocks in the S&P 500 hit 52-week highs, a sign that the market rally is broadening beyond the Magnificent Seven. Bitcoin is up more than 60% for the quarter, as investors poured a net $12 billion into the new bitcoin ETFs launched in January. With continued expectations of lower inflation and potentially lower interest rates, 2024 could prove to be another strong year for the markets.

With such a strong start to the year, returns are top of mind for everyone. 

Investors continuously strive to achieve the highest returns possible with minimal risk. But doing so is impossibly hard, since we can’t predict the markets or what asset classes will be this year’s winners. What we can do is be mindful of the factors we can control that ultimately impact how much of those returns we get to keep. And one of those factors — taxes — is often overlooked. Taxes can have an outsized influence on your after-tax investment performance, and ignoring them can easily mute hard-earned returns. While taxes have little to do with market behavior, they have everything to do with the portion of returns we retain. And since it’s tax season (oh, yay! … said no one ever), now is as good a time as any to review how being mindful of taxes can help you maximize what’s left in your pocket after paying Uncle Sam. 

One of the cardinal rules for minimizing taxes is to be mindful about when you realize capital gains. Long-term capital gains (those held for at least one year) are taxed at 0%, 15%, or 20% (depending upon your income), while short-term capital gains (those held for less than one year) are taxed at your ordinary income tax rates. If you’re in a high tax bracket (e.g., 37%), a $100 long-term capital gain means you keep $80 (assuming a 20% federal capital gains tax rate and no state tax). You’d have to earn 20% more, or $120 in short-term gains to keep the same (roughly) $80. 

Bottom line (pun intended): If you’re selling, make sure you keep an eye on how long you’ve held a position so you can be prepared for the tax consequences. Of course, there may be prudent reasons for selling earlier that eclipse any tax consequences; after all, paying higher taxes on a short-term gain is better than waiting and incurring a loss. 

Another impactful way to minimize current taxes is asset location, the intentional placement of investments across different account types to minimize current tax liabilities. Some types of investments, like stocks, are “tax efficient,” which means that any distributions (e.g., qualified dividends) are taxed at the more favorable tax rates (0%, 15%, or 20%). In contrast, “tax-inefficient” investments, such as corporate bonds, distribute interest income that's taxed at the typically higher ordinary tax rates. Placing tax-inefficient investments in tax-deferred accounts such as individual retirement accounts (IRAs) is considered advantageous, since the taxes owed are postponed and not taken out of the account. This allows the principal to grow tax-deferred until the investor retires and begins withdrawing from the account, at which point taxes are owed. A study from Vanguard shows that asset location can add between 0.05% to 0.3% of return annually.

Then there’s tax loss harvesting, the practice of selling investments that have declined in value and using those losses to reduce your current (and potentially future) tax bills. 

Here’s how tax loss harvesting works: You sell a losing investment and use that loss to offset any capital gains realized in the same year. If your loss is greater than the amount of your capital gains, you can apply the remainder of the loss against up to $3,000 of your ordinary income to reduce your tax bill that year (losses beyond that can be carried forward to offset gains in future years). The loss doesn’t lower your income tax directly; it offsets your gains and/or income, which is used to determine how much you owe in taxes. After the sale, you replace the losing investment with one that's similar, but not identical, to avoid wash sales and to maintain your target asset allocation. 

Note that tax loss harvesting is only useful in taxable accounts, and for most investors, it only defers taxes but doesn’t eliminate them (unless you gift the replacement investment or pass it down to your heirs). Why? In theory, the investment you purchased to replace the losing investment would have had losses similar to the one you sold. When it rebounds and eventually increases in value, you would owe taxes on any gains once you sell it. While it requires effort and diligence, tax loss harvesting can be a powerful tool for minimizing current taxes, especially during down markets like 2022. It’s why we offer it to Ellevest Wealth Management clients who can benefit from harvesting losses year-round. 

Given today’s interest rates, investors are actively allocating to cash and cash equivalents for yield. But not all yields that look the same are equal, once taxes are considered. A 5% yield on a municipal money market fund, on US Treasury Bills, and on an FDIC-insured cash deposit (CD) all lead to different after-tax returns. In taxable accounts, the interest from the CD will be subject to federal ordinary income and state taxes, while interest from US Treasury Bills will incur the same federal taxes but no state tax. Interest from municipal money market funds is exempt from federal income taxes and potentially state taxes, if the fund invests in municipals in your state of residence. And those checking and savings accounts that are finally yielding something above a fraction of a percent? Be prepared to pay both federal and state taxes on that interest. 

There are many kinds of tax-minimization techniques to help investors maximize after-tax returns. The ones above are just a few illustrations of how being mindful of taxes can impact your after-tax returns. Each investor’s financial situation and tax posture is unique, so be sure to speak with your financial advisor and tax professionals to determine what strategies would be most suitable for you. 

To learn more about Ellevest and how we help our clients build their wealth with a values-aligned investment strategy, you can schedule a call with us here.

Disclosures