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The Basics of Controlling Taxes and Costs in an Investment Portfolio

By on October 20, 2020
Categories: INVESTING

In a previous blog post, we covered two factors that investors can control – risk and diversification.

In this post, we’ll cover the last two – taxes and costs.

Minimizing taxes and costs is critical in maximizing the overall returns in your investment portfolio. After all, the after-tax and after-fee dollars is what is available for you to spend.

Paying Attention to the Tax Ramifications in Your Portfolio

To minimize taxes, you should focus on which investments you should put in your taxable accounts and which in your retirement accounts.

In a taxable account, you are subject to taxes incurred through your investments in a given tax year (such as capital gains and ordinary income).

When you sell a stock, for instance, for more than the purchase price, the gain is subject to capital gains tax. If you held the investment for more than one year, it would be considered a long-term capital gain. A long-term capital gain is taxed at a favorable rate of 0%, 15%, or 20%, depending on your taxable income bracket.

If you held the investment for one year or less, it’s considered a short-term capital gain. A short-term capital gain rate corresponds with your ordinary income tax rate. The ordinary income tax rate, which also applies to the interest that gets kicked off taxable bonds, can be as high as 37% at the federal level plus state income tax.

In a retirement account, the capital gains and ordinary income taxes are deferred until you withdraw the money. In the case of a Roth IRA, you are completely exempt from paying taxes upon withdrawal in retirement.

Here are examples of retirement accounts:

  • 401(k)
  • 403(b)
  • Traditional IRA
  • Roth IRA

Unlike taxable accounts, however, there are limits to how much you can annually contribute to these retirement accounts. In addition, rules exist about when you can withdraw money from a retirement account without potentially incurring taxes or penalties.

The type of account you hold your investments in can reduce the amount of taxes you ultimately pay and reducing this amount can increase your after-tax return on your investments.

Paying Attention to Your Investment Costs

The final factor you can control are the costs incurred through your investments. These costs (or fees) include:

  • Advisory fees
  • Fund fees
  • Trading costs

Here is a rundown on fees:

Advisory fee.

This is the fee you pay an advisor for managing your investments and personal finances. In most cases, this fee is charged as a percentage of total assets under management. You can find information on Dowling & Yahnke’s fees here.

Fund fees.

These fees, charged by mutual funds and exchange-traded funds (ETF), cover the operating costs for running these funds. These fees can vary significantly, even across two funds that maintain a very similar investment strategy. You can identify what the fund fee is for an ETF or a mutual fund by simply looking up that fund’s fact sheet online.

Trading costs.

These costs include the commissions incurred for buying and selling securities.

Bottom Line:

At the end of the day, paying attention to what you’re paying, from both a tax and a cost perspective, is critical in maximizing the overall returns in your investment portfolio.

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