Taxes and your investment returns

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Considerations for helping to manage your portfolio’s tax exposure

Michelle X. Wan, Investment Solutions Analyst, Wells Fargo Investment Institute
Michelle X. Wan
Investment Solutions Analyst
Wells Fargo Investment Institute
When I started my investment career at Wells Fargo 18 years ago, investors who were concerned about the impact of taxes on their investment returns in taxable accounts were typically heavily invested in tax-free municipal bonds. Today, investors can consider additional investment options. New tools and technologies assist your investment manager’s efforts to manage your portfolio’s tax exposure, helping to reduce the potential of unwanted expenses at tax time.

Let me give you a couple of examples of why taxes could surprise you:

  • It is important to consider how dividends are taxed. Qualified dividends are taxed at long-term capital gain rates. Nonqualified dividends, including payouts from Real Estate Investment Trusts (REITs) and other unearned income, are taxed at ordinary income tax rates. Higher income taxpayers also may be subject to a potential surcharge on unearned income.
  • Timing in purchasing a mutual fund also can have unintended tax consequences. Most mutual funds pass earnings to their shareholders towards the end of the year in the form of capital gain distributions. You will need to report the distribution from the fund for the whole year on your tax return, even if you purchased the fund just prior to the distribution. High portfolio turnover within the fund may cause larger distributions which may lead to higher taxes.

The long and short of investments and taxes is that if investors aren’t careful, their tax bills may be higher than anticipated depending on the types of investments owned. So to keep it simple, are investors better off investing only in tax-free muni bonds to manage their taxes? The answer is not necessarily.

Besides taxes, investors may also consider income needs and return expectations when making investment decisions. You and your advisor may have decided that investments such as REITs are an appropriate addition to your portfolio based on your investment objectives. You also may decide that the timing of buying a mutual fund makes more sense just before a distribution rather than waiting until it likely will not have a tax impact. The tax tail shouldn’t wag the investment strategy dog.

I am not saying that investors shouldn’t consider investing in tax-free municipal bonds. These bonds may be appropriate for tax-efficient allocations. Investors may want to consider owning them as part of a well-diversified portfolio in taxable accounts. For example, consider the optimal allocation between risk and return profile of your equity allocation, as well as income needs from dividends. Emerging market investments tend to be less tax-efficient due to their high fees and high turnover. The ultimate allocation towards different asset classes needs to factor in an investor’s tax situation in addition to risk and return.

So what may you want to consider if you want to help ensure that you’re making tax planning a year-long exercise?

  • Review your portfolio with your financial advisor to make sure that it’s aligned with your investment objectives—remember, that taxes are a consideration but shouldn’t drive your investment decisions.
  • If you are unsure about the investments you own, ask your advisor for additional information
  • If you are concerned about your tax exposure, ask your advisor about tax-advantaged portfolios. Make sure you consult with your tax professional about the potential impacts of your investments.

Wells Fargo Investment Institute, Inc. is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

This article has been prepared for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Individuals need to make their own decisions based on their specific investment objectives, financial circumstances and tolerance for risk. Please contact your financial, tax and legal advisors regarding your specific situation and for information on planning for retirement.

All investing involves risk including the possible loss of principal. Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve.

Diversification does not guarantee profit or protect against loss in declining markets. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.

Stocks may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Dividends are not guaranteed and are subject to change or elimination. Bonds, including municipal bonds, are subject to interest rate, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates.

Real estate-based investments: There are special risks associated with an investment in real estate, including the possible illiquidity of the underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Investments in fixed-income securities are subject to market, interest rate, credit and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can cause a bond’s price to fall. Credit risk is the risk that an issuer will default on payments of interest and/or principal. This risk is heightened in lower rated bonds. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity. Yields and market value will fluctuate so that your investment, if sold prior to maturity, may be worth more or less than its original cost. Income from municipal securities is generally free from federal taxes and state taxes for residents of the issuing state. While the interest income is tax-free, capital gains, if any, will be subject to taxes. Income for some investors may be subject to the federal Alternative Minimum Tax (AMT).

Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges and expenses carefully before investing. The prospectus, which contains this and other information, can be obtained by calling your financial advisor. Read the prospectus carefully before you invest.

Wells Fargo Advisors is not engaged in rendering legal, accounting, or tax advice. If legal, accounting or tax assistance is required, the services of a competent professional should be sought.