Want to maximize the wealth you’re building without letting taxes chip away at it? When it comes to building wealth through investments, it’s not just about how much money you make but how much you keep.
Taxes can eat into your returns, but tax-efficient investing can help you hold on to more of what you’ve earned. By strategically choosing the right accounts, assets, and timing, you can maximize returns while minimizing tax liabilities.
Whether you’re new to investing or looking to optimize your strategy, understanding tax-efficient investing and making smart money moves with taxes in mind could accelerate your path to reaching your financial goals.
Key Takeaways
- Tax-efficient investing aims to maximize after-tax returns by minimizing tax liabilities.
- Different investment accounts offer varying tax advantages, such as tax-deferred or tax-exempt growth.
- Asset location, investment selection, and transaction timing are key strategies for tax efficiency.
- Tax-managed funds, municipal bonds, and Treasury bonds are common tax-efficient investment vehicles.
- Financial advisors can provide personalized strategies to optimize tax efficiency based on individual goals.
What Is Tax-Efficient Investing?
Tax-efficient investing is a strategy to use specific products and accounts in a portfolio to maximize returns and minimize the taxes paid on those returns.
Think of tax-efficient investing like a game of chess. Rather than just focusing on the next right move, you’re thinking steps ahead about what mix of taxable and tax-advantaged products and accounts keep more of your money in play.
Types of Investment Accounts
To master the tax-efficient investing strategy, you must first understand the two main types of investment accounts: taxable and tax-advantaged.
Taxable Accounts
Taxable accounts, like brokerage accounts, are investment accounts that allow investors to buy and sell investments like stocks, mutual funds, and exchange-traded funds (ETFs). Taxable accounts have no contribution limits or withdrawal penalties, but account owners have to settle up with Uncle Sam at tax time when they make money on their investments.
Investments earn money in two main ways: capital gains and dividends.
Capital gains are the profits you make when you sell an investment for more than you paid. Capital gains are taxed based on how long you’ve held the investment and how much money you make. Capital gains on investments held under one year are taxed at your ordinary income tax rate. Investments held longer than a year are taxed at different rates: 0%, 15%, or 20%.
Note
Higher capital gains tax rates of 25% and 28% may apply to the sale of certain commercial properties or collectibles, respectively.
Dividends are payments companies distribute to their shareholders as a share of their profits. Dividends are either qualified and taxed at 0%, 15%, or 20%, or nonqualified (ordinary) and, you guessed it, taxed at your ordinary income tax rate.
Tax-Advantaged Accounts
Tax-Deferred Accounts
Tax-deferred accounts allow you to contribute pre-tax dollars and grow your investments without paying taxes until you withdraw the money. Notable tax-deferred accounts are traditional individual retirement accounts (IRAs) and 401(k) plans. Because contributions are tax-free, they reduce taxable income in the year of the contribution. You’ll pay taxes when you withdraw your money- ideally, when you may be in a lower tax bracket in retirement.
Tax-Exempt Accounts
Contributions to tax-exempt accounts are made with after-tax dollars, but the big payoff is that qualified withdrawals are entirely tax-free. These accounts, like Roth IRAs and Roth 401(k)s, are occasionally overlooked because investors don’t reap the benefits until retirement. But these “what you see is what you get” accounts can be a game-changer, especially for retirees who need every dollar to count after their peak earning years.
Strategies for Tax-Efficient Investing
Asset Location
To maximize returns and minimize tax liabilities, you want to avoid placing investments that are already tax-advantaged into tax-advantaged accounts. Similarly, you wouldn’t want to keep all your high dividend-paying stocks in a taxable account. By strategically placing the right assets in the right accounts and considering the tax treatment of each asset and account, you can invest tax-efficiently and keep more money in your pocket.
Investment Selection
Just like there are taxable and tax-advantaged accounts, individual investments can be tax-efficient, too.
Tax-efficient investments, like tax-managed funds, exchange-traded funds (ETFs), treasury products, and municipal bonds, can significantly reduce tax liabilities when strategically used. Tax-managed funds and ETFs typically generate fewer capital gains, which can lower your tax burden. Additionally, certain treasury products and municipal bonds allow investors to avoid paying local, state, or federal taxes, further enhancing tax efficiency and savings.
Timing of Transactions
When trying to win the tax-efficiency chess game, you need to think several moves ahead, and sometimes that means selling investments strategically to help control your tax bill.
Strategic selling includes tactics like holding assets for long-term capital gains rates and tax-loss harvesting. Capital gains taxes are based on your income and how long you’ve held an asset. If you hold an asset for over a year, gains are taxed at a lower long-term capital gains rate.
Note:
Tax-loss harvesting lets you offset losses in a down market against your gains, helping to reduce your tax bill down the road.
Common Tax-Efficient Investment Vehicles
Tax-Managed Funds and ETFs
Tax-managed funds and ETFs are baskets of securities designed to minimize risk and minimize taxable distributions. These assets minimize buying and selling transactions to keep capital gains in check.
Because these accounts actively keep tax liabilities as low as possible, they’re well-suited for taxable accounts.
Municipal Bonds
Municipal bonds are issued by state and local governments to fund day-to-day operations or special projects like building public schools or highways. Municipal bonds’ interest income is exempt from federal taxes—and often from state and local taxes if you live in the issuing state.
Treasury and Series I Bonds
Treasury bonds and Series I bonds are both government-backed fixed-income investments. They both also boast tax-exempt interest at the state and local levels. Investors, particularly those in high-tax states, can greatly benefit from state-free interest income in taxable accounts.
| Taxable Accounts (e.g., brokerage accounts) | Tax-Advantaged Accounts (e.g., IRAs and 401(k)s) |
|---|---|
| Individual stocks you plan to hold for at least a year | Individual stocks you plan to hold for less than a year |
| Tax-managed stock funds, index funds, exchange traded funds (ETFs), low-turnover stock funds | Actively managed stock funds that generate substantial short-term capital gains |
| Qualified dividend-paying stocks and mutual funds | Taxable bond funds, inflation protected bonds, zero-coupon bonds, and high-yield bond funds |
| Series I bonds, municipal bond funds | Real estate investment trusts (REITs) |
What Is the Difference Between Tax-Efficient Investing and Tax Avoidance?
Tax-efficient investing is a strategy for legally reducing taxes while maximizing returns, whereas tax avoidance involves illegal tactics to deliberately evade taxes. This type of investing requires careful adherence to tax laws and regulations.
What Are the Potential Risks Associated With Tax-Efficient Investing?
Tax-efficient investing may limit investment options or lead to under-diversified portfolios. Ultimately, tax-efficient investing is only part of an investment strategy, and the key to success is to balance tax considerations with overall investment goals, risk tolerance, and timeframe.
What Is the Least Taxed Investment?
Investment purchases in Roth IRA accounts are made with after-tax dollars, but qualified withdrawals are tax-free in retirement. Of non-retirement-related investments, government-backed securities like municipal bonds, treasury bonds, and Series I bonds are the least taxed.
Can Tax-Efficient Investing Strategies Be Applied to Retirement Accounts?
Retirement accounts are inherently part of a tax-efficient investment strategy. To amplify the tax efficiency of these accounts while considering your own circumstances, consider investing in high-dividend or high-growth funds inside your account. For some facing higher taxes in retirement, a Roth conversion may be the most tax-efficient course of action.
How Can Investors Track the Tax Efficiency of Their Portfolios?
Investors should review annual tax forms for capital gains distributions or dividends paid. They may also want to consult their financial or tax advisors periodically to review their portfolio’s efficiency. Finally, they should stay up to date on contribution limits for retirement and tax-advantaged accounts and contribute as much as possible while still allocating enough funds for non-retirement-related goals.
The Bottom Line
Tax-efficient investing is a powerful strategy for minimizing the tax impact on your investment returns. By using smart tactics like asset location, transaction timing, and investment selection, you’re not only building wealth but also keeping more of what you’ve worked hard to grow for the future.
Since everyone’s financial situation is unique and tax-efficient investing can be complex, consider consulting a financial advisor to tailor a strategy to your specific goals, risk tolerance, and timeline.
