There are many factors to consider when constructing a personal investment strategy. Most investors have near-, mid-, and long-range goals, which can determine how they allocate money and what types of assets they hold. There’s also the matter of managing the costs of investing. Investing, like most things in life, isn’t free.
These costs generally fall into two broad categories: fees or commissions for investment advisers and related services, and taxes. Taxes, of course, are inevitable, but they can cut into your returns. There are ways to minimize, defer, and spread out the taxes you’ll pay through balancing your portfolio in a way that makes it more tax efficient.
What is tax-efficient investing?
Tax-efficient investing is an approach to investing in which you endeavor to minimize or spread out your tax burden. It involves choosing some investments for which you can defer tax payments and others that are taxed for the year you make gains on them.
Taxes can cut into investment returns in two ways:
- The dollars an investor spends on taxes themselves, and
- The opportunity those taxed dollars lose to be invested.
There are a number of investing strategies that aim to achieve efficiencies when it comes to taxes. These are the steps you might want to consider when researching tax-efficient investments:
- Selecting and timing investments;
- Choosing which investments to hold in taxable accounts and which to hold in tax-advantaged accounts;
- Limiting federal income taxes by taking strategic tax breaks on charitable giving; and
- Discussing your timeline with an advisor who can help you manage your tax strategy for different life goals.
Taxable vs. tax-advantaged investment accounts
There are essentially two tax buckets into which investments fall: taxable and tax-advantaged. In taxable accounts, you pay taxes on your gains in the year that you earned the gains. In tax-advantaged accounts, you usually pay taxes later. The different kinds of accounts have various advantages and disadvantages. Most investors have a mix of both.
Assets such as stocks, bonds, exchange-traded funds (ETFs), and index funds held in taxable accounts will generate tax liabilities for any gains realized or income earned. In other words, if you sell a stock for a profit or receive dividends, you’ll pay taxes. The advantage of these taxable accounts is that they’re liquid. You can withdraw the money anytime, with no age restrictions and no penalties.
Investments in taxable accounts are subject to different tax rates. For instance, if you hold investments for at least a year, you would pay long-term capital gains rates, which are generally lower than short-term capital gains taxes. Long-term capital gains top out at 20%, depending on your tax bracket. If you hold an investment for less than a year, gains you make are subject to short-term capital gains taxes, which can go as high as 37%.
Tax-advantaged accounts are designed to encourage saving for retirement. But there are tradeoffs. For instance, if you take out money from certain types of accounts, you’ll pay taxes on the withdrawals. You’ll also sacrifice flexibility in exchange for the tax advantage.
Tax-advantaged retirement plans, such as 401(k)s, annuities, and IRAs, require you to wait until a certain age to withdraw. Early withdrawals often result in penalties in addition to the taxes due. These types of accounts also have yearly limits on how much you can contribute, and in the case of Roth IRAs, those with higher incomes may not be permitted to make any contributions.
Tax-advantaged accounts fall into two categories: tax-deferred and tax-exempt.
- Tax-deferred: A tax-deferred account, such as a traditional IRA or 401(k), lets you deposit and invest money now, without paying income taxes until years later when you withdraw the money.
- Tax-exempt: Roth accounts, meanwhile, are considered tax-exempt plans. You contribute to the plans with after-tax dollars, but your money gets to work tax-free and you won’t pay taxes on the withdrawals you take in retirement.
Tax-efficient investing strategies
Investors often consider strategies to reduce or spread out their tax burden.
Diversify by tax treatment
Some investors choose to diversify their portfolios by the way their investments are taxed. For instance, they might contribute to both a traditional IRA or 401(k) and a Roth IRA, in addition to keeping investments in a brokerage account.
Contributions to a traditional IRA are usually made with pretax money, so taxes would be paid on withdrawals at some point in the future—usually in retirement when most people have a lower tax rate. Contributions in a Roth IRA are made with after-tax dollars, and any withdrawals after the age of 59 ½ (from accounts that are at least five years old) are free of federal taxes, and in some cases, state taxes as well.
Different accounts for different investments
Since different types of investments are taxed at different rates, some investors choose tax-deferred accounts for investments that would normally incur higher tax rates. For instance, they might choose taxable accounts for individual stocks that they hold for a year or more, as those qualify for the lower long-term capital gains rate. And they might choose a tax-advantaged account for the investments that might yield the larger short-term capital gains and the higher taxes that would go with them.
Tax-efficient investing may change depending on an investor’s plans for managing an estate. For example, stocks that are passed on in an inheritance might be more appropriate for taxable accounts. Any taxes due if the shares are sold will be calculated starting with the cost basis, which is calculated based on the market value when an investor dies, not the price paid when the shares were bought years ago.
The tax code encourages philanthropy. You can deduct the value of charitable giving from taxable income, within some limits, and you can maximize the value of the gift in several ways. For instance, investors who contribute appreciated stocks or mutual funds instead of cash may be able to eliminate capital gains taxes. Investors can set aside multiple years of contributions in one year by donating through a donor-advised fund, which is a charitable fund created to manage charitable donations.
Types of tax-efficient investments
Some investments may be more tax-efficient than others:
- Exchange-traded funds, or ETFs, are pooled investments that are designed to track an index, sector, or commodity. ETFs held in a taxable account can be more efficient than a mutual fund in the same account because ETFs tend to generate fewer taxable events than a mutual fund, many of which buy and sell securities often, resulting in capital gains that lead to tax liabilities.
- Municipal bonds, or the debts issued by an agency or government to raise money, are tax-efficient because the interest income they pay isn’t subject to federal income tax. They can also be exempt from state and local taxes. But different municipal bonds can have different tax implications, so investors may need to consider the specific rules on individual bonds and consult a tax adviser.
- REITs, or real estate investment trusts, are pass-through businesses, which means that the business is not subject to corporate income taxes; rather, an investor’s proportional share of the trust’s profits are “passed through” to them as income to report on their individual tax return. To qualify as a REIT, the trust has to distribute the vast majority (90%) of its taxable income to shareholders. Still, you’ll want to talk to a financial adviser about how that dividend will be taxed. It will generally be treated as ordinary income but could be classified as a capital gain or a return on capital.
- Treasury bonds, or the securities the US Treasury issues to finance government spending, are tax-efficient assets because they’re exempt from state and local income taxes. They are, however, fully taxable at the federal level.
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