How To Make Your Portfolio Tax Efficient

Occasionally, people tell me that they worry about investing because of all the taxes that they may accumulate over time. This is really only a major concern if you happen to be a high net worth individual or a small business owner. However, with the right planning process, these alleged taxes can be mitigated from ordinary, passive, and portfolio income, the purchase/sale of assets (real estate), and retirement/estate planning.

For more information regarding portfolio tips and taxes, visit Investopedia.

Tax Planning and Investing Go Hand-in-Hand

First let’s talk about tax mitigation strategies. Tax mitigation is simply the idea of developing investment strategies that reduce your taxes as well as potentially grow your wealth. The choices you make when assets are in motion have tax consequences, and how you manage those consequences can either cost or save you in taxes.

To better understand, let’s look at possible sources of income. There are four categories of income: earned income, investment income (which includes passive income and portfolio income), tax-deferred income, and my favorite—tax-free income. Each category offers different strategies and vehicles to reduce or defer taxes. 

What is ‘Earned Income’?

Earned income is compensation from employment or the actual involvement in a business. This is the most highly taxed form of income and is the most limited in terms of deductions. With earned income, deductions are generally available after the income is received. For example, if you’re contributing to a pre-tax retirement account that is based on your income, you won’t know how much you can contribute until you have received your income.

What are ‘Portfolio and Passive Income’?

Portfolio income is derived from investments and includes capital gains, interest, dividends and royalties. Investments held longer than 12 months have preferred tax rates. Losses can offset gains. Passive income is derived from activities in which you do not actively participate, such as real estate or limited partnerships. Losses have the ability to offset passive income.