Financial advisor discussing tax efficient investments with clients
Financial advisor discussing tax efficient investments with clients

A Beginner’s Guide to Tax-Efficient Investing 

Let’s be honest: none of us enjoys handing hard-earned money over to the IRS, but we’re all responsible for paying taxes. The good news is that taking advantage of tax-efficient investing and using tax-advantaged accounts allows you to retain more of your earnings and defer tax liabilities. 

Why is tax-efficient investment important? 

Taxes can eat away at your investment gains and impact your overall returns. Since saving for retirement is often dependent on compounding, you can see a greater impact by keeping more money up front. By adopting tax-efficient investment strategies, you can:

  • Maximize after-tax returns and keep more of your hard-earned money working for you.
  • Reduce current and future tax obligations, freeing up capital for further investments or other financial goals.
  • Improve portfolio diversification and enhance your portfolio’s resilience.
  • Mitigate the risk of adverse tax consequences.
  • Allow your investments to grow tax-free or tax-deferred for extended periods, harnessing the power of compounding.

Remember, there are two reasons why minimizing the amount of taxes you pay can have a significant effect on returns:

  1. You’ll gain the money that you would have paid in taxes.
  2. You gain the compounding growth of that money if it remains invested.

How to invest tax-efficiently

Tax-efficient investing revolves around two primary principles: selecting tax-advantaged accounts and choosing tax-efficient investments. Although there are advantages and disadvantages to each kind of account, the types you use are important aspects of your investment strategy. You can optimize your returns by strategically allocating investments across taxable and tax-advantaged accounts and selecting tax-efficient assets. 

Types of investment accounts

Taxable accounts

Taxable accounts, such as brokerage accounts, offer no tax deferral benefits. However, they provide flexibility and fewer restrictions compared to tax-advantaged accounts. Investment returns in taxable accounts are subject to taxes based on the holding period, with long-term gains taxed at preferential rates. Capital gains rates on long-term dividends and capital gains can be up to 15 points lower than ordinary income rates on interest and earned income.

With a taxable account, you also have the opportunity to offset capital gains with capital losses as long as you adhere to the wash sale rule (avoid selling and purchasing the same or a similar security within 60 days—30 before your loss sale, and 30 after).

Tax-advantaged accounts

Tax-advantaged accounts, including traditional IRAs, Roth IRAs, 401(k)s, and health savings accounts (HSAs), are generally either tax-deferred or tax-exempt. 

Tax-deferred accounts, like traditional IRAs and 401(k) plans, give you a tax break right away. You may be able to deduct your contributions, which means you pay less in taxes right now. You’ll owe taxes when you take money out during retirement, hence the name tax-deferred.

Tax-exempt accounts, such as Roth IRAs and Roth 401(k)s, work differently. You fund these with money you’ve already paid taxes on, so you don’t get an immediate tax break like you do with traditional accounts. However, your investments grow without being taxed, and when you take money out in retirement, it’s tax-exempt. That’s why they’re called tax-exempt accounts.

You may also be interested in: IRA to Roth conversion

The trade-off with both types of accounts is that while you get tax benefits, there are rules about when and how you can take out money. These rules are often age-based or based on when you retire, but there are exceptions.

What are the most tax-efficient investments?

Certain investments are inherently more tax-efficient than others:

  • Equities: Equities may pay dividends, which are subject to capital gains taxes if you have held the investment more than a year.  
  • Bonds: Bond interest is generally taxed at ordinary income tax rates. However, municipal bond interest is tax-exempt. Keep in mind that tax efficiency may come with lower interest rates. Speak with your financial advisor before making any investment decision, and never make decisions on tax impact alone.
  • Real estate: Real estate investments offer various tax deductions, favorable capital gains treatment, and potential incentives. However, real estate investing can be complex, and holding rental properties comes with its own set of rules regarding passive activity losses, depreciation recapture, and determining what expenses can be taken or deferred. 

Tax-efficient investing strategies

To implement tax-efficient investing effectively, consider the following strategies:

  • Contribute the maximum allowable amounts to retirement accounts, 529s, and HSAs to benefit from tax-deferred or tax-exempt growth.
  • Consult with your financial advisor to discuss the advantages and disadvantages of placing tax-inefficient investments in tax-advantaged accounts and tax-efficient assets in taxable accounts to minimize tax liabilities.
  • While municipal bonds and other tax advantaged investments may provide you with tax efficiency, discuss how to best implement this strategy with your financial advisor to make sure it fits with your long-term goals.
  • Have a conversation with your financial advisor about tax-loss harvesting and whether it makes sense to use losses to offset gains. Be aware of the 30-day wash sale rule that could make your losses ineligible.
  • Understand ETFs and mutual funds that you own. Sometimes these funds will have unexpected capital gains that are taxable to you even though the proceeds were reinvested.
  • If you are required to make Required Minimum Distributions (RMDs) from tax deferred IRA accounts, consider making those as a direct Qualified Charitable Distribution to charities you support. Doing so directly reduces your taxable income, even if you don’t itemize deductions.

Other investment tax savings opportunities: gains and losses

If you have some unrealized gains in the tax year, you may have an opportunity to sell and lock in the income tax-free. Did you have some significant capital losses from stock sales last year? These losses will carry over to the following year until they can be applied against capital gain income. The result is that net gains you have this year, up to the loss carryover amount from previous years, aren’t taxed at all. (But, of course, you shouldn’t let tax considerations be the sole reason you sell a security.)

On the loss side, if you have sold some stocks for a gain and have other stocks that are down, it may pay to sell those stocks to lower your taxable capital gains. You can sell a stock for a loss and then repurchase it 31 days later. If you want to sell the stock to harvest the loss but not stay out of that particular industry, you can avoid the 31-day waiting period by purchasing a different stock in the same industry.  

Minimize tax liabilities, focus on after-tax returns, and pave the way for your financial goals

Although tax-efficient investing becomes more important when your tax bracket is higher, it’s not just a luxury for the wealthy—it’s a prudent strategy for all investors looking to optimize their after-tax returns and achieve their financial objectives. Consulting with a financial advisor or tax professional can provide invaluable guidance tailored to your specific circumstances, ensuring you make informed decisions on your investment journey.

Schedule a consultation with one of our advisors if you need help creating or optimizing your tax-efficient investment strategy. 

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