An investment portfolio with a mix of stocks and bonds will produce three types of investment return: interest, dividends and capital gains. Added together, they make up what is known as “total return”. Inside an IRA or other qualified account, the relative mix of investment return does not matter. A 5% return is a 5% return, regardless of whether it comes from interest, dividends or capital gains. In a taxable investment account, however, the story is much different.
With a taxable investment account, taxes are generally due each year based on the interest, dividends and capital gains earned inside the account. However, each type of investment return is taxed differently. Interest income and short-term capital gains are taxed at a taxpayer’s “ordinary” income tax rate, while qualified dividends and long-term capital gains are generally taxed at a lower, preferential rate. In addition, unrealized Gains are deferred. In other words no capital gains tax is due as long as an investment is not sold.
Knowing this, we can then design a tax efficient investment portfolio accordingly. We can weight our portfolio toward investments that generate returns through qualified dividends, long-term capital gains, and unrealized capital gains. Examples include broadly diversified index and passively managed stock mutual funds. These funds exhibit low turnover and produce much of their return in the form of deferred capital gains and qualified dividends.
In addition, we can avoid investments that produce higher levels of interest income and short-term capital gains. Examples include a portfolio of high yield bonds or actively managed stock portfolios with high turnover and therefore high levels of short term capital gains.
If you have any questions about this or to learn more about how we build tax efficient portfolios for our clients, please contact our offices at 561-491-0231.
Core Wealth Management is a fee-only wealth management firm located in Jupiter, FL. Our CFP® professionals provide investment management, financial planning and advisory services, while always strictly abiding by the highest fiduciary standards. For more information, contact us today at 561-491-0231.
Todd Schanel, CFP®, CPA, CFA, CVA is the Principal and Director of Investment Advisory Services at Core Wealth Management. He is a member of the CFA Society of South Florida.