Considerations for helping to manage your portfolio’s tax exposure
Investment Solutions Analyst
Wells Fargo Investment Institute
When I started my investment career at Wells Fargo twenty 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 a nasty surprise at tax time.
Let me give you a couple of examples of why taxes could trip you up:
- 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 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. 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 also can trigger higher taxes.
If not carefully managed, your tax bill may be higher than you have anticipated depending on the types of investments you own. So to keep it simple, are you better off investing only in tax-free muni bonds to manage your taxes? The answer is not necessarily.
Today investors have the options to consider a full tax-efficient allocation that provides guidance on an optimized portfolio with tax considerations. Investors could also consider gaining exposure to asset classes through tax-efficient investment vehicles such as separately managed accounts, ETFs, and other actively managed portfolios that employ tax loss harvesting.
That is not to say that you shouldn’t consider investing in tax-free municipal bonds. We see favorable municipal credit fundamentals and believe demand will remain strong in 2025. My point is, consider owning them as part as of a well-diversified portfolio in your taxable accounts.
So what should you be discussing with your advisor if you want to help ensure that you’re making tax planning a year-long exercise?
- Review your portfolio with your 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 for additional information
- If you are concerned about your tax exposure, ask about tax-advantaged portfolios
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.
Wells Fargo & Company and its affiliates do not provide tax or legal advice. This communication cannot be relied upon to avoid tax penalties. Please consult your tax and legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your tax return is filed.
All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security. There is no assurance any investment strategy will be successful. Asset allocation does not guarantee a profit nor does diversification protect against loss.
Investments in fixed-income securities, including municipal securities, are subject to market, interest rate, credit, liquidity and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. High yield fixed income securities are considered speculative, involve greater risk of default, and tend to be more volatile than investment grade fixed income securities. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. These bonds are subject to interest rate and credit/default risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and Investments in fixed-income securities, including municipal securities, are subject to market, interest rate, credit, liquidity and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. High yield fixed income securities are considered speculative, involve greater risk of default, and tend to be more volatile than investment grade fixed income securities. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. These bonds are subject to interest rate and credit/default risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income.
Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Investments in equity securities are generally more volatile than other types of securities. There is no guarantee that dividend-paying stocks will return more than the overall stock market. Dividends are not guaranteed and are subject to change or elimination.
