Even as volatility leaves financial advisors' clients wondering how to address their portfolios, it's important to remember that certain choices — such as developing a tax-efficient investing strategy — can make a big difference no matter the market environment.
1. Municipal Bonds and Municipal Bond Funds
While interest from taxable bond funds — taxed at the investor's ordinary income tax rate — can hit returns, that's not the case with municipal bonds and municipal bond funds, Benz wrote. Muni bonds and funds aren't subject to federal income tax, and clients also may be able to avoid state or local taxes on municipal bonds or bond funds tied to their state or city, she added.
A client's tax bracket may play a role in choosing the type of bonds for a taxable account, Benz noted. While municipal bonds and municipal bond funds make sense for those in higher tax brackets — 24% and higher — taxable bonds might produce a better yield for investors in lower tax brackets.
She suggested high-quality, short-term municipal bond funds for near-term goals, and longer-duration or lower-quality funds for longer-term spending needs.
Benz also cited municipal money market funds as an appealing choice for taxable accounts, saying they tend to make sense for higher-income investors who need to maintain liquid reserves on an ongoing basis. "There are broadly diversified municipal money market funds as well as ones that focus on bonds from a specific state; those might be especially attractive for high-income people who live in high-tax states like California," she told ThinkAdvisor.
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2. I Bonds and Series EE Bonds
Municipal bonds are more attractive than these U.S. government bonds when it comes to tax efficiency, but clients can avoid state and local taxes with I bonds and Series EE bonds, according to Benz. Clients with incomes below certain thresholds can avoid federal taxes as well if they redeem EE bonds for qualified educational purposes, she added.
I bonds bought before November 2022 come with a 9.62% interest rate for the six months following the purchase date. Clients can purchase up to $10,000 in I bonds per year on TreasuryDirect.gov and another $5,000 if they use their federal income tax refund, Benz noted.
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3. Stocks
Taxable accounts can be good places to hold individual stocks for clients who choose to invest in them, especially if they make infrequent trades, said Benz. While mutual funds can result in capital gains taxes even if the investor hasn't sold shares, clients won't owe capital gains on individual stocks until and unless they sell the securities at a profit, she said.
"Generally speaking, limiting trading is a way to avoid realizing capital gains. However, some of the tax-loss harvesting systems involve more frequent trading — netting gains against losses on an ongoing basis in an effort to reduce the taxes that will be eventually due upon sale. So it's too simplistic to suggest that never trading is always a good way to lower taxes. But it's generally a smart policy," she explained to ThinkAdvisor.
Benz cautioned that investors will owe taxes on distributed dividends and recommended therefore that they keep high-dividend stocks in tax-sheltered rather than taxable accounts.
That advice doesn't necessarily apply to clients with more modest incomes, however. Investors in the 0% tax bracket for qualified dividends and long-term capital gains (under $41,675 in taxable income for single filers and $83,350 for married couples filing jointly) "can go ahead and gorge" on high-dividend equities, Benz wrote.
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