You can have great returns on your investments, but if Uncle Sam is taking a lot of those gains through taxes, you ultimately end up with below-average returns.
The first step to prevent this is to invest in vehicles with very low portfolio turnover. Low portfolio turnover equals low capital gains. Some mutual funds invest specifically with this strategy in mind; however, exchange-traded funds (ETFs) based upon large indexes are ideally suited for this purpose.
The second step is to balance equity holdings with bond holdings. Municipal bonds offer tax-free income; however, in the event of a severe market downturn, these bonds provide little protection. It may be tempting to buy bonds that are free from state and local taxes, but it is important to focus on diversification to reduce risk. This means owning municipal offerings from states other than your primary residence, even if this results in some state income tax having to be paid.
If the goal of the bond portfolio is to provide protection along with tax-free income, it is important to maintain a position in high credit-quality bonds, including Treasuries. While Treasuries are not tax-free for federal purposes, they do have the advantage of being state income tax-free.
Another strategy is to utilize a loss harvesting strategy. With the tremendous number of ETFs available, this has become a very easy strategy to implement while maintaining a consistent asset allocation strategy and overall diversification. Let’s say an investor owns SPY, an ETF that mirrors the S&P 500 Index, and has a loss. This loss can be realized and the investor can turn around and invest the proceeds in OEF, the ETF that mirrors the S&P 100 Index. By doing this, the investor has not significantly changed his asset allocation or diversification.