Advice from financial experts are as varied as the types of investments they suggest -- and all too often, few pay attention to the tax consequences when making their recommendations. This week, I'll cover the pros and cons of common investment advice for tax-advantaged accounts.
As the saying goes, only two things in life are certain, death and taxes. You can’t control one, but you can limit the other. In this post, we’ll focus on minimizing taxes using tax-advantaged accounts.
A given here, of course, if that no investor wants to lose money. This is even truer in tax-advantaged accounts, because these capital losses can’t be deducted from income tax. This has led some specialists to recommend placing conservative investments in these accounts, ones that are not likely to suffer intrinsic losses over time. This includes bonds with higher yields and ideally no chance of default. (Though, granted, these can be a hard find these days.) Also typically recommended are Treasury Inflation Protected Securities (TIPS) because they pay dividends that are taxed and the dividend may increase in the future in the event of inflation.
Financial experts that are less conservative suggest taking on a bit more risk in tax-advantaged accounts by investing in high-yielding stocks, exchange traded funds (ETF) or mutual funds. (For example, a high-yielding real estate investment trust (REIT) or utility ETF.) These investments, of course, have a greater chance of losing intrinsic value in a downturn than bonds, but they are also likely to turn around with the market in time.
Aggressive investors try to make more money in tax-advantaged accounts by what I believe to be the triumph of hope over reality. They invest in high-turnover funds that imply they can give back a large profit. Since no one can reliably predict the future, these types of funds are not optimal for most investors because they stand a chance of losing investable money to trading costs, as well as the potential for lackluster performance.
In summary, the object is not to lose money, but to keep it in a tax-advantaged account and make a profit at the same time. The most generally accepted secure way to do this is with high-grade, high-yielding bonds and inflation-protected bonds. Next in line, in terms of a combination of safety and return, are high-yielding stocks, mutual funds or ETFs. They give back a premium to their owners, though they can be more capricious in the short-term, nevertheless, they offer the advantages of high return and long-term stability over time. Lastly, those funds with a promised high return and turn over are most whimsical and only for those with an appetite for risk that are willing not only to stand a gain but to lose capital in the worse possible case.
These guidelines fall right in line with Warren Buffet’s first rule, “Don’t lose money.” His second: “Don’t forget the first rule.”
Read Part II of my two-part series on tax-smart investment strategies.
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