Spring isn’t the only time to think about taxes. Strategic, year-round tax planning can be one of the most effective ways to protect and grow your wealth. Consistently finding ways to reduce your tax burden, if they’re modest, can have a compounding effect on your long-term investment returns.
At Fulton Private Bank, we work closely with you—and in coordination with your tax and legal advisors—to help identify tax-efficient strategies tailored to your overall wealth goals. Your private banker serves as a knowledgeable partner in helping you make the most of every opportunity.
Here’s a look at how taxes can impact the returns on your investments, along with the benefits of integrating tax optimization strategies into your overall wealth management plan.
What is tax optimization?
Tax optimization is a key part of wealth management that involves reducing the impact taxes have on your investments in legal and strategic ways. It’s not about eliminating taxes altogether, but instead about reducing how much you owe the IRS so you can maximize the after-tax returns on your investments.
There are a variety of tax optimization strategies that can help reduce your overall tax burden, improve the effective rate of return on your portfolio, and grow your wealth over time. In fact, you may already be using some of the most common strategies, such as maxing out your allowable contributions to your 401(k) or Roth IRA. Other tax optimization strategies include investing in municipal bonds, donating money or assets to charity, starting a donor-advised fund, selling underperforming investments to offset gains, and reallocating income-generating assets into tax-advantaged accounts—just to name a few.
When used consistently, tax optimization strategies can make a measurable difference in your financial health. They’re most effective when integrated into your overall wealth management plan and broader goals, rather than something you tweak once a year during tax season.
How taxes erode investment returns
The performance of investments is often measured in pre-tax terms. While that can help you compare funds or strategies more easily, it doesn’t account for tax drag. The concept describes how the tax burden on capital gains, dividends, and interest income can erode your earnings in ways that add up. Even a small reduction in annual returns can compound over time, reducing the potential for your wealth to grow by hundreds of thousands of dollars in some cases.
For example, let’s say you have a $1 million investment that earns a 6 percent annual return over 20 years. That’s a pre-tax return of $3.2 million. But if tax drag reduces your effective return to 4 percent, your portfolio would instead grow to roughly $2.2 million. That’s about $1 million in lost growth just due to taxes.
Now, let’s look at what happens if you reduce your tax burden and bring your effective annual return to 5.5 percent. After 20 years, your portfolio would grow to roughly $2.9 million—$700,000 more than the value of the tax-inefficient portfolio. This shows how tax optimization strategies can be powerful tools for making sure more of your returns stay in your portfolio and help you build wealth throughout your life.
How to make tax optimization part of your wealth plan
It’s not always clear which tax optimization strategies apply to your specific situation or how to implement them effectively. Everyone’s financial picture is a little different, and the right approach can depend on a variety of factors, such as your income level, portfolio mix, investment time horizon, personal values, and future goals.
For example, a 529 plan might be appropriate if you expect future educational expenses for a child or grandchild, while a donor-advised fund can be smart if you're looking for more ways to support causes you care about. Both options can help reduce your tax burden, but each has its own purpose that may work better for one person over another.
Working with a tax professional or private banker can provide clarity about the role of tax optimization in your overall wealth planning. They can explain the pros and cons of all the strategies available to you, help you figure out which ones are most advantageous for your circumstances, and make adjustments to your financial plan as your situation changes. For instance, they may recommend strategically selling declining investments to help offset other gains in a volatile market.
Tax optimization strategies aren’t set in stone. They can change depending on legislation, market conditions, and your personal circumstances. Working with a professional can help you stay up to date on all the options available to you, integrate proactive tax planning into your broader financial plan, and adjust your approach whenever it’s smart to do so—not just when you’re filing your taxes.
Connect with a private banker today to learn how tax optimization can be a tool for protecting and growing your wealth over the long term.
