tax preparation

Best Investment Strategies that CUT your Tax Bill

Investments and Taxes are a lot like Pineapples, don't you think?

Investments and Taxes are a lot like Pineapples, don't you think?

As you may or may not know PJF Tax has a sister company Phillip James Financial, a wealth management company. Because of this our tax clients enjoy the benefits of expert investment advice along with quality tax advice. These two disciplines often cross paths. With that in mind our blog post this we is about the best investment strategies that can cut your tax bill. 

A mistake that most investors make is not considering how taxes effect their overall return. This includes local, state, and federal taxes and they can take a large chunk out of your investments earnings. It's very important that you have a strategy to minimize the impact of these taxes otherwise most of it will end up in the hands of the IRS, which nobody wants.

Utilize Tax Efficient Investments

The more tax efficient an investment is the higher your "After-Tax" rate or return, which is really the most important return number to look at. Think about it. If you have an investment that provides a 10% rate of return but is taxed at 50% your after tax return is only 5%. Compare that to an investment that earns 8% but is only taxes at 15%. In this case your after-tax rate of return is 6.8%. Much better than the 10% even though it didn't seem that way at first. 

There is really spectrum of tax-efficient when it comes to investments. I.e. Investment aren't just tax-efficient or tax-inefficient, they are relatively efficient. Investment A is more efficient than investment B. Get it?

Generally, investments that derive most of their return from appreciation are more tax efficient. This is because capital gains tax rates are lower than ordinary income tax rates. Keep in mind this is only the case if the investments are held long-term, meaning more than 1 year. If a capital gain is realized before one year they are taxed at ordinary income tax rates anyways. Keep this in mind when buying and selling out of your investments.

Another very tax efficient investment is municipal bonds. These bonds are more efficient because, in general, the interest earned on them is tax free at a federal level and also tax free at a state level if you happen to live in the state where the bonds were issued. Note you can buy individual municipal bonds but most investors buy them through a mutual fund or ETF (exchange traded fund). There are some state-specific muni bonds funds but they are harder to find and can be more expensive. Therefore, you might be better off buying a general muni bond fund, foregoing the state tax savings, and just taking the federal tax-free income.

Use Tax-Advantage Accounts

Just like some investments are more tax-efficient, different account types can also be more tax efficient. There are three types of tax advantage accounts, taxable, tax-deferred, and tax-free. 

Individual and Joint brokerage accounts are taxable. This is the simplest account type that you can open. There are no tax benefits which means if you sell an appreciated security you have to pay tax on the gain in that year. As well, if you earn interest or dividends you have to pay tax on that income in that year.  Usually these accounts are used after you have reached the maximum contribution for all the tax-advantaged accounts you have available to you. 

Tax-Deferred accounts are accounts that accounts allow your money to grow tax free until the money is withdrawn from the account. Examples of these type of accounts are 401(k)s, Traditional IRAs, 529 College Savings Plans and Health Savings Accounts (HSAs). Many times you will receive a tax deduction for your contributions or if the contributiosn were made through your employer through salary deferral you won't have to include that income on your tax return. 

Tax-Free accounts are Roth IRAs and Roth 401(k)s. These accounts don't provide you any immediate tax benefits but the investments grow tax-free and when they are withdrawn from the account they are not taxed.  

It is generally a good idea to hold your more tax-inefficient investments in your tax advantaged accounts (tax-deferred and tax-free). Then you tax-efficient investments can be held in your taxable accounts. This will help minimize the taxes you have to pay on your investments. 

Consider you Holding Period

As I briefly mentioned before, you should hold onto your investments for at least one year. Any gains you realize on your investments held more than a year are taxed at the beneficial long-term capital gains rates. The highest long-term capital gains rate is 20% but most people will only pay 15%. If you don't hold your investments for more than a year they are taxed at your ordinary income tax rate which could be as high as 39.5%.  So, keep this in mind if you have an investment with a large gain. It might make sense to hold on for a little longer.

Tax-Loss Harvesting

When the markets are volatile you might be able to harvest losses from your portfolio and use them to offset some gains for any given tax year. This is a strategy known as tax-loss harvesting. Here is an example of how this works. Let's say tomorrow you buy $50,000 of Mutual Fund ABC. Then over the course of a month the markets are down 10%. You have a $5,000 unrealized loss on your investment. From a tax perspective this doesn't do you any good. So you "Harvest" the loss by selling funds ABC and then purchase another fund, say XYZ at the same time. This accomplishes two things. 1) You now realized the loss which can be used on your tax return to offset any gains and 2) You maintained your exposure to the market so when it goes back up you get the benefit.

(See Tax Loss Harvesting Made Easy on the Phillip James Financial Blog)

You can also use up to $3,000 per year in losses to offset ordinary income (not just to offset gains). You can also carry forward any losses that you don't use in any given year to use in future tax years. You should also note that you cannot buy the same investment that you just sold within 30 days otherwise you violate something called the "wash sale" rule and won't be able to use those losses. 

Mutual Fund Turnover Ratios

Every mutual fund (and ETF) has a fund manager that buys and sells stocks and bonds for the fund. How often they buy or sell those funds is called the turnover ratio. A high turnover ratio means that the manager trades often. For example a 100% turnover ratio means that the portfolio will be completely different at the end of the year when compared to the beginning. I see a lot of problems with this but from a tax perspective it's going to increase your tax bill because of eh capital gains that the fund generates.

This is why we are big proponents of index funds. They are designed to track an index an index and since indexes don't change very often they have low turnover. Not to mention that most index funds beat their actively managed counterparts. It's a win/win!

Don't Sell Appreciated Securities Donate Them

When you have investments that are highly appreciated you should consider donating them to your favorite charity. This is a better idea than just donating cash because now no one has to pay the tax on the capital gains. The charity still gets the full value of the securities in the donation. This is a no-brainer than most people don't think about when writing their annual donation check. Just ask the charity you want to make a donation what their process is for handling donated securities. 

Investing is not about what you make it's about what you keep (or keep away from the IRS)! Use these strategies I laid out to trim your tax bill and keep more of your money for yourself. If you're financial advisor isn't making these suggestions maybe it's because they are not a tax professional. This is why we offer both services to our clients both Tax Preparation and planning along with Financial Planning and investments. If you want to have everything handled in one place reach out for a meeting!


Today let’s talk about 5 itemized tax deductions that can you big money this tax season. But before we get into that we can quickly go over the difference between itemized versus standard deductions.


Schedule A is the way you itemize your deductions. It’s basically a list of all your itemized deductions for the year. But you only use this form if you are itemizing. You can either itemize or take the standard deduction. The standard deduction is really just that, the standard deduction that the IRS allows you to take each year. The amount depends on your tax status (Single, Married Filing Jointly, Head of Household, etc.) and whether or not you are claimed as a dependent by someone else. You can also get an additional standard deduction if you are blind and/or over the age of 65. You don’t have to track or prove anything. You can take this deduction every year no matter what. Itemized deductions are things like medical costs, long-term care, property taxes, mortgage interest, personal property tax and many others. If you’ve tracked this information throughout the year you can choose whether or not you want to take the standard deduction or the itemized. Basically choose the larger amount as it will give you the biggest tax benefit. You can work it out both ways to see which is best for you. (We do this for you if PJF is preparing your taxes.)

One thing to keep in mind is if you itemize, the alternative minimum tax could kick in if your income is too high. What that means is your deductions are added back to an alternative tax calculation to determine if you need to pay a minimum amount of tax. Basically, you calculate tax two different ways. It’s the IRS’ way of making you pay a minimum amount of tax even if you have a lot of itemized deductions.

So if you are itemizing this year here are the 5 itemized tax deductions to look for to help lower your taxable income.

  1. Sales Tax or Income Tax – If you live in a state like Minnesota with income tax you can deduct all of the income that you pay over the year. If you are using a tax software it will usually take this deduction for you. The thing to look for is if your income is low this year (or there is no state sales income tax) you should deduct your sales tax instead. For example, if you purchased a car you might have paid a large chunk of sales tax on that purchase. As long as you have documentation to prove it you can deduct this along with all of the other sales taxes you’ve paid over the year. Consider calculating both income and sales tax to make sure you are taking the largest deduction possible.
  2. Property Taxes – This is all of the taxes that you pay related to your personal or real property. The biggest one could be your primary residence but could also include your vacation property (assuming you don’t rent it out – if you do then the taxes would go on schedule E). This deduction also includes auto and boat registration taxes. Basically any state or local taxes that you paid throughout the year charged on personal property, based on the value of the property and charged on an annual basis
  3. Mortgage Interest Deduction – This is the mortgage interest paid on your primary interest and vacation/second home. However, you only get to deduct the interest on up to $1,000,000 of mortgage debt. I know this seems like but I’ve seen cases where a primary residence and cabin debt get over the $1,000,000 mark pretty quickly. We love our cabins in Minnesota!
  4. Charitable Contributions – This is any donation to non-profits like cash or non-cash items like clothing and household goods. Keep in mind if the value is over $500 you have fill out the additional 283 Form. And if the value is over $5,000 you have to get the item appraised. Do not appraise it yourself the IRS won’t count this.
  5. Miscellaneous Deductions – Some examples of these things could be safe deposit boxes, estate planning fees,  tax preparation fees, unreimbursed employee expenses, investment management fees, casualty losses, and gambling losses (only to the extent you have gambling gains.  Keep in mind most of these deductions are subject to 2% of you AGI meaning the combined amount of these expenses have to be over 2% of your adjusted gross income in order to be deductible at all.

There you go, the five deductions you need to take this year if you’re itemizing. The 6th item that I left off the list is Medical deductions. I left if off because it is harder to meet the threshold. If you are older than age 65 it is subject to 7.5% of your AGI and for everyone else is 10% of your AGI. If you’ve itemized in previous years you should consider taking a look to make sure you took every deduction on this list. If not you can amend a tax return within three years of the date you filed or within two years form the date you paid the tax, whichever is later.