Quarterly Investment Foundations Fourth Quarter 2024

Mastering The Subject

Decreasing Tax Costs on Investment Income

Taxes can significantly impact the long-term growth of your investment portfolio. By carefully managing how your investments are taxed, you can reduce your tax bill and improve your overall returns. A key part of this strategy involves understanding the difference between ordinary and qualified dividends, asset location, and how to manage tax costs.

Understanding Dividends: Ordinary vs. Qualified

Dividends are payments made by companies to their shareholders, usually from their profits. There are two main types of dividends that investors need to understand: ordinary dividends and qualified dividends.

Ordinary dividends are taxed at your regular income tax rate. This rate can range from 10% to 37%, depending on your total income. Qualified dividends, on the other hand, are taxed at the lower capital gains tax rate, which can range from 0% to 20%, depending on your income. This tax treatment makes qualified dividends much more tax-efficient for many investors.

For a dividend to be considered qualified, it must meet certain requirements set by the IRS. The stock must be held for a specific period of time, and the company paying the dividend must be a U.S. corporation or a qualifying foreign corporation. Additionally, certain types of stocks are more likely to generate qualified dividends, such as large U.S. and foreign companies, compared to REITs (Real Estate Investment Trusts) or bond funds, which tend to generate ordinary income.

Funds and Qualified Dividends

Some fund managers focus on creating funds that produce higher levels of qualified dividends than others. For example, funds that buy and sell stocks less frequently or invest in certain international stocks may generate more qualified dividends. By selecting funds with higher qualified dividend payouts, investors can potentially lower their tax burden, which increases the amount of money they keep in their pockets.

Asset Location: A Key Tax Strategy

Another important way to reduce tax costs is through asset location. Asset location means placing certain investments in different types of accounts based on how they are taxed. For example, placing the highest-growing assets—such as stocks that generate qualified dividends—into accounts with the lowest tax rates, like a Roth IRA, can help decrease your lifetime tax costs. In contrast, it makes sense to hold investments that generate ordinary income, such as bonds, in tax-deferred accounts like a traditional IRA or 401(k), since those accounts are taxed at ordinary income tax rates upon withdrawal.

Imagine a farmer who selects ideal soil and planting conditions for each type of crop to ensure a bountiful harvest. He might plant hearty crops in rich, sunlit soil for maximum growth and reserve fields with less sun for those crops that can tolerate shade. At Grand Wealth, we approach asset location similarly, placing investments in accounts where they are most likely to thrive and yield the highest after-tax growth. By placing high-growth assets in tax-advantaged accounts, and income-generating assets in tax-deferred accounts, we create the ideal growing conditions for each investment to achieve its full potential over time.

Failing to use proper asset location can increase your tax costs unnecessarily. For instance, if you hold stocks that generate qualified dividends in a traditional IRA, the income will eventually be taxed at ordinary income tax rates when you withdraw it. This means that income, which could have been taxed at a lower rate in a taxable account, is instead taxed at a higher rate, costing you more in taxes.

By carefully placing assets that produce different types of income into the most tax-efficient accounts, you can reduce your tax burden over time. This approach is an important part of Grand Wealth Management’s philosophy of tax-efficient investing that helps our clients maximize their after-tax returns.

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Market Check-In:

- Economic Overview: The U.S. economy continued to show strength in the third quarter of 2024, driven by solid consumer spending and a resilient labor market. Inflation, which had been a concern over the past few years, is finally trending down toward the Federal Reserve’s 2% target. This, combined with interest rates starting to fall, has provided a stable backdrop for both stock and bond markets. The Federal Reserve cut short-term interest rates by 0.5% in September, a move that could signal further rate reductions in the coming months.

- Stocks Performance: U.S. stocks had another strong quarter, returning 5.9%. Large-cap U.S. companies continue to drive much of the gains, benefiting from stable economic conditions. International developed stocks outperformed U.S. stocks, returning 7.7% for the quarter, while emerging market stocks led the pack with an 8.7% return. Although U.S. stocks have delivered strong returns over the past year, international and emerging market stocks remain undervalued relative to their U.S. counterparts. This creates potential opportunities for investors looking to diversify their portfolios beyond the U.S. market.

- Bonds Performance: The bond market also saw strong performance in the third quarter. U.S. bonds returned 5.2%, and global bonds returned 7%. The Federal Reserve’s interest rate cut in September helped boost bond prices, as lower rates tend to increase bond values. With expectations of additional rate cuts later this year and in 2025, bond prices may continue to rise. Investors should keep in mind, however, that bonds will still fluctuate in response to interest rate changes, and it’s important to maintain a diversified portfolio that balances both stocks and bonds to manage risk effectively.

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_{Disclosure:
This newsletter is for informational purposes only and does not constitute investment, legal or tax advice and should not be used as a substitute for the advice of a professional legal or tax advisor. Certain information contained herein was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. Grand Wealth Management ("GWM") is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about GWM including our investment strategies, fees, and objectives can be found in our ADV Part 2, which is available upon request.}