Tax planning begins when building your portfolio. Here’s what you need to know

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If you’re still recovering from the tax sting of larger-than-expected mutual fund payouts in 2021, it’s never too early to prepare for future distributions, according to financial experts.

Mid-year capital gains distributions aren’t common, especially in a bear market year, said Russel Kinnel, director of manager research for Morningstar. “And it should be a pretty light end to the year, barring a huge rally.”

But investors still need to be proactive going forward since “90% of what you can do is at the portfolio building stage,” Kinnel said.

Your 401(k) plan or Individual Retirement Account can protect you from annual income tax, such as dividends or capital gains. But your brokerage account is taxable, which means you may have to pay annual business levies.

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“I certainly take that into consideration when designing portfolios for clients,” said JoAnn May, certified financial planner and CPA at Forest Asset Management in Berwyn, Illinois. “I always keep asset taxation in mind when strategizing where things are going to go.”

If you have three types of accounts — brokerage, tax-deferred and tax-exempt — it’s easier to choose the best location for each asset, May said.

Since bonds may have less growth but distribute income, they may be suitable for tax-deferred accounts, like your 401(k) plan, she said, and investments most likely to appreciate may be ideal for tax-free accounts, such as a Roth IRA. .

However, if you don’t have all three account options, there may be other opportunities for tax efficiency, May said.

For example, if you have a large enough bond portfolio, you may need to place some assets in a brokerage account. But depending on your income, you might consider municipal bonds, she suggested, which generally avoid federal levies and possibly state and local interest taxes.

Other assets to avoid in a brokerage account are real estate investment trusts, or REITs, which must distribute 90% of taxable income to shareholders, said Mike Piper, CPA at the firm on his behalf in St. Louis.

“If you must have [funds] in taxable accounts, you want to make sure it’s generally something with low turnover,” he said.

Exchange-traded funds or index funds generally generate less income than actively managed mutual funds, which typically pay out at year-end.

All-in-one funds

Another investment that is better suited to tax-deferred or tax-free accounts is an all-in-one fund, which attempts to create a complete portfolio, as a target fund, an age-based retirement asset.

Because all-in-one funds contain different types of assets, it’s not possible to put certain parts, such as income-generating bonds, in a more tax-efficient place, Piper explained. .

These investments also limit your ability to use tax losses or sell loss-making assets to offset gains, because you can’t change the underlying holdings, he said.

For example, suppose your all-in-one fund contains US stocks, international stocks, and bond funds. If there is a decline in national stocks, you cannot reap those losses by selling only that part, whereas you can have that choice if you own each fund individually.

You may also see excess turnover of the underlying funds, creating capital gains that can be taxed at regular income rates, depending on how long you hold them.

“They really aren’t suitable for taxable accounts,” Piper added.

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