Investors tend to be delighted by a winning year in the markets until they get clobbered by a big income tax bill. While taxes aren’t completely avoidable, there are a number of strategies you can use to minimize them:
Tax consequences of mutual funds, ETFs, and Individual Stocks
1) Mutual funds tend to incur higher tax bills than other forms of investment, unless you are a frequent trader. Avoid mutual funds that jump in and out of stocks frequently. The more a mutual fund trades the more tax bills you will incur. Index funds usually have the lowest tax bills of all the mutual funds.
2) Consider substituting exchange-traded funds (ETFs) for mutual funds. ETFs can still incur unwanted taxes, since they must buy and sell to match a particular index. Unlike mutual funds, however, you won’t incur taxes due to other investors’ redemptions. By buying and selling directly on the market, you control when you incur gains. Unfortunately, ETFs are not as useful when dollar cost averaging with small amounts of money, so smaller and more cautious investors may not be able to take advantage of this feature.
3) Individual stocks are the most tax-friendly of all, assuming you are a long-term investor, but you’ll need to do more work to invest in them intelligently. By holding sound companies for many years, you can build wealth while incurring no tax at all (except on any dividends the companies may pay).
Minimizing taxes by selling winners at the right time
1) Avoid selling stocks and funds just because you have profits. Studies show that frequent traders do worse than long-term holders. Sell only when you have lost confidence in the future of a stock or fund.
2) Go for long-term capital gains treatment whenever possible. The capital gains tax is lower on long term gains than on short term ones. Long term gains treatment occurs whenever an investment is held for a period of more than one year. Thus, it is foolish to take gains in less than a year unless you believe the stock is due for a significant price drop.
Minimizing taxes by selling losers at the right time
1) It is often advantageous to sell your losers before year’s end. You are allowed to claim your capital losses in any given year, and losses can be used to offset capital gains. Losses not used can be carried over and used in the next tax year. There are two times when you might want to hold on to your losers: a) The company is a sound one, and you have carryover losses from the previous year that already offset all your gains and allow you the maximum possible deduction or b) You believe that a turnaround in the share price is immanent, and that it will exceed the benefit of taking the loss.
Keep in mind that the Superficial Loss Rule prevents you from repurchasing any stock upon which you’ve claimed a loss for a period of 30 days. Failure to observe this rule could mean your loss will be disallowed and added to the cost of the newly purchased stock.
2) Try to balance gains and losses. When you want to take a big gain, look for losses you can balance against it to minimize your tax bill.
Minimizing taxes by holding assets in retirement accounts
You can avoid or postpone taxes on dividends and gains by holding stocks and bonds in an RRSP or TFSA account. In a RRSP, gains are tax free until you withdraw the funds. In a TFSA, they are tax free forever.
It is therefore advantageous to hold bonds, high-yielding stocks, and stocks you trade frequently in your RRSP or TFSA account, and keep non-registered accounts for your long-term, low-yield holdings.
You can save money on your taxes by carefully considering the type of investment you purchase, the times when you buy or sell it, and whether you hold it in registered (RRSP or TFSA), or a non-registered account. By saving money on your taxes, you increase your total returns. Remember, though, that you’re in the market to make money. Never let tax considerations keep you from selling a stock whose best days are over.