4 practices to avoid in tax aware investing

Published on December 2, 2020 | 3 min read | LPL Financial

Tax aware investing focuses on optimizing your returns by reducing your tax liability as much as possible. In theory, this investment strategy has the potential to help you earn more money on your investments, but you need to be aware of some potential pitfalls. When getting started with tax aware investing, you may want to avoid the following practices.

1. Don’t exclusively let taxes drive decisions

With tax aware investing, you always need to keep the tax implications of your investment decisions in the back of your mind, but you cannot let this single factor drive all your decisions.

Just as you do with traditional investing, you also have to weigh the potential for gains when choosing between different investments or deciding if you want to sell an investment. You also need to keep in mind your tolerance for risk, your budget, your long-term investment goals, and multiple other factors while investing.

2. Don’t just take pre-tax gains into account

Ultimately, the goal of investing is to realize a gain, but when you’re looking at the potential gain of an investment, you should not just consider the amount earned. Instead, you should calculate the amount earned minus the potential tax liability.

To give you an example of how these elements may affect your decision making process, imagine that you buy some stocks. You earn a healthy return on the stocks so you want to sell them, but if you sell right away, you face short term capital gains which diminish the value of your return.

To ensure you optimize your returns, you crunch the numbers and decide to keep the investment for a few more months. This is possible because the stock is continuing to rise in value. Then, when you finally sell the stocks, you have long term gains which are generally taxed at a lower rate. Note that this is just a basic example. In reality, there are multiple other factors to take into account.

3. Don’t rely on one-size fits all investment strategies

When looking for a finance professional to help with your investments, you may want to choose someone with experience with tax aware investing, but if possible, you should try to avoid financial professionals who use a one-size fits all approach to investing. Different people have different tax situations, and when seeking investment advice, you need guidance that is tailored to your unique situation.

4. Avoid overly complicated portfolios

The tax code is relatively complicated, and if you are trying to minimize your tax liability, you may want to avoid complicating the situation with an overly complicated portfolio. For instance, you may want to avoid overlapping mutual funds or exchange-traded fund (ETF) exposures, but these are just examples. Ultimately, you and your financial professional need to decide which investments are right based on your goals and tax situation.

Important disclosures

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The information provided is not intended to be a substitute for specific individualized tax planning or legal advice. We suggest that you consult with a qualified tax or legal advisor.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.

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