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Tax-Advantaged Investments – A Guide


When investing for the short- or long-term, where you choose to put your money matters from a tax perspective. Including tax-advantaged investments in your investment portfolio can help to minimize what you owe on the returns you earn. Tax-advantaged investments can include individual securities but it can also refer to accounts that receive favorable tax treatment. Here’s more on how to leverage tax-advantaged investments in a portfolio.

Consider working with a financial advisor to find the tax-advantaged securities that best fit your goals, risk profile and timeline.

Tax-Advantaged, Definition

Tax-advantaged is a general term that can describe an individual investment, investment plan or investment account. In simple terms, it means any type of investment or investment product that allows investors to enjoy preferential tax treatment. This can include investments that are:

  • Tax-free or tax-exempt, meaning no tax is owed on profits
  • Tax-deferred, meaning investors can defer payment of taxes owed on gains to a future date

So why does tax status for investments matter? It’s simple. The more tax-advantaged investments you have working on your behalf, the more of your investment returns you get to keep. Over a lifetime of investing, higher taxes can drastically shrink the amount of wealth that you’re left with. So keeping taxes on a tight rein can help you ensure that your dollars and cents are working for you at maximum efficiency.

Managing investment taxes becomes more important as your portfolio grows. If higher returns from an investment would put you in a higher tax bracket, for example, it’s important to understand what that means from a capital gains tax perspective. Likewise, the more you earn the more you may be able to set aside in tax-deferred accounts to minimize current taxation.

Types of Tax-Advantaged Investments

When discussing tax-advantaged investments, there are two sides to consider: individual investments and tax-advantaged accounts. On an individual level, some investments tend to be more tax-efficient and tax-friendly than others. In terms of which types of investments tend to be most tax-efficient, they include:

  • Municipal bonds
  • Annuities
  • Exchange-traded funds (ETFs)

Municipal bonds are bonds that are issued by state and local governments. When you invest in a muni bond, you’re effectively loaning a state or local government money. Once the bond matures, you receive your initial investment back and you also earn interest on the bond.

So why are municipal bonds tax-advantaged? First, interest earned on these bonds is exempt from federal tax. And second, the interest they earn can also be exempt at the state or local level, depending on where the bond is issued.

While there are other types of bonds to choose from, including Treasury bonds and corporate bonds, they don’t enjoy the same tax treatment as municipal bonds. Being able to avoid taxes at three different levels is rare, which makes municipal bonds are a favorable choice for tax-advantaged investing.

Annuities can also be beneficial in a portfolio you’re looking for a tax-deferred investment option. With an annuity, your investment grows tax-free until you begin withdrawing funds. That includes anything you earn through interest, dividends or capital gains. While the guaranteed income aspect of annuities is often what makes them so popular, their tax benefits shouldn’t be overlooked.

Exchange-traded funds or ETFs are another option for saving money on investment taxes. ETFs are mutual funds that trade on an exchange like a stock. Passively managed ETFs and index ETFs typically have a lower turnover of fund assets compared to actively managed funds. This passes on a tax advantage to investors in the form of fewer capital gains tax events.

Tax-Advantaged Investment Accounts

Asian male investorWhile you may choose specific investments based on their tax features it’s important to decide where to keep them. This is where it helps to know the difference between taxable brokerage accounts and tax-advantaged accounts. Brokerage accounts allow you to buy and sell stocks and other investments, free of any annual contribution limits or income restrictions. You can open a taxable brokerage account online in minutes and with low minimum investment in some cases.

But there’s a catch. Any investments you sell at a profit out of your account are subject to the short- or long-term capital gains tax, depending on how long you owned them.

Tax-advantaged accounts, on the other hand, may be subject to annual contribution limits and income restrictions. But you can either defer paying taxes on your investments until you begin taking withdrawals or you may be able to avoid taxes altogether.

Tax-advantaged accounts include:

When an account is tax-deferred, contributions are made with pre-tax dollars and no tax is due until you withdraw money. A traditional 401(k) or traditional IRA is tax-deferred. These accounts can also offer the benefit of a tax deduction for contributions.

Accounts with a Roth designation, including a Roth 401(k), Roth IRA or even a Roth Thrift Savings Plan, are funded using after-tax dollars. That means since you’ve already paid taxes on contributions you won’t pay any taxes when you withdraw money later. The trade-off is that you don’t get a tax deduction for those contributions.

If you’re hoping to maximize tax efficiency, it makes more sense to keep tax-advantaged investments in a brokerage account rather than a tax-deferred account. That’s because you’re already minimized taxation on those investments so there’s no need to try and do it further with a tax-deferred account. On the other hand, investments that are less tax-efficient, such as traditional mutual funds or real estate investment trusts (REITs), might be a better fit for a 401(k) or similar account.

Also, consider the timing when deciding where to place investments. Again, with a brokerage account, any profits you realize are subject to the capital gains tax rate. The long-term capital gains rate is more favorable than the short-term rate so it could make sense to place investments you plan to own for longer than a year here while placing shorter-term investments in a tax-advantaged account.

The Bottom Line

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Tax-advantaged investments could help you save money on taxes when building a portfolio for the long term. An investment that’s tax-advantaged can allow you to defer taxes, avoid paying them altogether or enjoy other tax-related benefits. Talking to your financial advisor or a tax professional can help you create the right strategy for minimizing taxes as much as possible, without sacrificing your investment goals.

Tips for Financial Planning

  • Not sure where to begin with tax planning for your investments? A financial advisor can help you find the best way to approach taxes and which tax-advantaged investments are right for you. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. With SmartAsset’s financial advisor matching tool, you can get personalized recommendations for professional advisors in your local area in minutes. If you’re ready, get started now.
  • Use SmartAsset’s tax return calculator to see how your income, withholdings, deductions and credits impact your tax refund or balance due amount. This calculator is updated with rates and information for your 2020 taxes, which you’ll file in 2021.
  • When investing in a taxable brokerage account, consider the benefits of tax-loss harvesting. This strategy allows you to minimize taxes by selling investments at a loss to offset capital gains. Some online brokerages and robo advisors will harvest losses for you automatically, while others require you to do this yourself. When done correctly, tax-loss harvesting can be an effective way to trim your tax bill and make the most of your investment gains.

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