“The only difference between death and taxes is that death
doesn’t get worse every time Congress meets.”
— Will Rogers

This seems like a timely quote since we’re in the middle of a big election cycle — and highlights a big factor in investing.

My first few columns have been on planning, market risk and strategies to reduce it, with diversification being key. My last column talked about costs.

But the impact of taxes is an often-hidden risk that can take a toll on long-term outcomes.

Taxes reduce returns for two reasons: you lose the money you pay in taxes and you lose the growth that could have been generated if it were still invested.

You can’t control either death or taxes, but you can certainly try to influence them. So, let’s talk about tax-aware investing: strategies that can improve investment outcomes.

Note that while I’ve had many years advising clients on financial and investment matters, I am not a CPA and have always felt clients are best served when tax and legal advisers are part of the planning team.

It seems helpful to consider how the IRS treats investment income.

Ordinary income, including interest income from bonds and cash, is currently taxed at individual rates of up to 37%.

Profits from the sale of stocks held more than a year qualify as long-term capital gains with a maximum tax rate of 20%. If you sell stocks held less than a year, gains are taxed as ordinary income.

For both types of income, a 3.8% net investment tax may apply. And don’t forget state income taxes; California’s top rate can be as much as 14.4%.

Bottom line: Taxes matter and thoughtful planning can pay off.

Here are some ideas:

• Hold assets that produce little or no income in taxable These tend to include growth stocks/stock funds and tax-efficient index funds/ETFs.

• Put higher income generating assets in tax-deferred retirement accounts (IRAs, 401ks). This might include bonds/bond fund, money market funds and CDs.

• High-bracket taxpayers might consider tax-exempt bonds. The after-tax “effective yield” might be higher than taxable choices.

• Try to avoid selling stocks you’ve held for a year or this would avoid having gains taxes at higher ordinary income rates.

• Look for opportunities to tax-loss. Turn lemons into lemonade.

• Be strategic about retirement accounts. In general, delay withdrawals while you’re working and be sure to meet requirement minimum distribution rules.

• Don’t let the tax-tail wag the investment dog. Buying or selling investments just to avoid taxes could be very counter-productive.

The first two ideas are about “asset-location” — choosing the most tax-effective place to hold different kinds of investments.

If your overall strategy calls for a 60/40 stock/bond mix, why not put the taxable bonds in your IRA or 401k, which accumulate on a fully tax-deferred basis, and hold the stock portion in a taxable account?

If bond allocations exceed tax-deferred account limits, high-bracket taxpayers might consider tax-exempt municipal bonds for excess funds. (A 3.5% municipal bond beats a 5% taxable bond in a 40% tax bracket).

California taxpayers might want to look at California municipal bonds, which are exempt from both federal and state taxes.

But what about capital gain taxes?

First, try to avoid paying top rates by selling stocks you’ve held a year or less — but again, investment decisions come first.

Second, look for investment products that are at least “tax-aware.” Investors can be surprised when mutual funds report capital gains distributions at year-end, even if they lost money in the fund.

So, look at unrealized gains in a fund before you buy, and look at fund turnover to see what you might expect going forward.

Index funds are typically more tax-efficient than actively managed funds, so they’re a worthwhile option to consider.

Actively managing for taxes takes more work, but can produce nice benefits.

While nobody likes losses, they can present some impressive tax benefits with thoughtful planning.

Let’s say a stock or mutual fund you own has fallen quite a bit below what you paid for it. You could sell it, book the loss, and reinvest proceeds in a similar (but not identical) holding.

Example: you invested $10,000 in Coca-Cola (KO), which has fallen in value to $6,000. Sell the KO and buy Pepsi (PEP).

Book the $4,000 loss, which can be used to offset other gains this year or carried forward to offset future gains — yet funds stay invested for a future recovery.

You could even sell the Pepsi and buy back the Coca-Cola after a 31-day wash sale period ends if you preferred the KO.

I took advantage of this big time during the Great Recession” of 2007-2009, selling assets for clients at big losses but promptly reinvesting in similar holdings.

Losses captured helped clients offset substantial gains on future investment gains (even real estate sales), and clients participated in the recovery that began in March 2009. Truly turning lemons into lemonade.

Tax-managed (“direct indexing”) products take this idea to a higher level. With this product, you have a separately managed account (SMA) holding a sizable sample of individual stocks designed to track an index.

Computer systems look for holdings that can be loss-harvested (kind of like Pac-Man eating dots) and then automatically replacing them with a similar security.

Remember, the market as a whole might be up, but there are almost always individual securities that are down. Without any promises, these products can often closely follow the selected index return while beating the index by 1%-2% on an after-tax basis.

There are a growing number of providers, and it is likely best to consult your investment professional and tax advisers about these sophisticated products.

Tax-deferred retirement accounts require special tax-planning attention. Many plans now offer traditional or Roth options, allowing you to decide whether to take your tax benefit up-front or when funds are withdrawn.

You might want to consider Roth conversion options at some point — particularly if you have a very low-income year.

And there will come a time for withdrawals, to meet living costs and those required by the IRS.

Under current rules, taxpayers must take “required minimum distributions” (RMDs) by age 73. RMDs are the minimum amount that must be withdrawn at each age — of course, you can always take more.

RMDs start at about 4% of the account value at age 73 with payouts increasing with age (to more than 8% by age 90).

One popular idea for folks who are philanthropically minded and don’t need all the money paid out each year is to use RMDs to make “Qualified Charitable Donations” (QCDs).

Now, consider the saying “nothing is for sure except death and taxes” as they intersect with significant income, gift and estate tax considerations.

There’s even a basis step-up at death — seemingly about the only good thing that comes with dying. Estate taxes can take a huge toll on those lucky enough to have accumulated a very large net worth.

Complex to say the least — with advice from experienced legal and tax advisers important — and Will Rogers’ quote as valid today as ever with frequent tax-law changes.

Final note: It has long been my experience that outcomes are best when financial, tax and legal advisers serve folks as a team — each providing a unique perspective and professional experience to the planning table.

Paying for good advice can be a good investment.