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Tax Efficient Investing – A Guide

Woman doing her taxes

Tax efficient investing allows investors to reduce, delay and otherwise manage taxes generated by investment activities, potentially improving after-tax returns. Investors can use a variety of methods to manage taxes efficiently, including selecting tax-advantaged investments, practicing tax-aware strategies and using IRAs, 401(k)s and other tax-deferring accounts. Sorting through the various ways to boost the tax efficiency of your investing can be confusing, which is why working with a financial advisor can help cut down on your tax bill.

Tax Efficient Strategies

One way to reduce tax impact is to follow tax efficient strategies. Here are some of the most common and effective ones:

  • Capital gains strategies – One of the most widely used tax strategies is delaying the sale of investments in order to take advantage of long-term capital gains treatment. Gains on investments held less than a year are taxed as ordinary income, while gains on assets held more than a year are taxed as long-term capital gain rates of 15% for most investors.
  • Loss harvesting – By selling money-losing investments you can shelter gains on profitable investments from taxes. When losses on investments in a given year total more than investment gains for that year, the losses can shelter up to $3,000 of earned income. Plus, losses can be carried forward to later years.
  • Charitable donations – Investors who itemize taxes can deduct the value of gifts to charitable organizations, within certain limits. Charitable giving strategies include donating appreciated securities for fair market value without having to sell them and create a taxable gain and bunching donations during high-income years.
  • Timing fund distributions – Investors who own mutual funds on date of record for a distribution of interest, dividends or capital gains can incur an instant tax liability. Investors should be aware of these dates of record. In some cases, it may be advisable to wait until after the distribution date of record to purchase a mutual fund.

Tax Efficient Accounts

Roth conversion kit

Tax efficient investing often combines selection of accounts and investments with the tax-efficient strategies summarized above. For instance, investments that generate taxable dividends may be kept within IRAs or other tax-deferred accounts, while tax-reducing investments such as municipal bonds are kept within regular taxable brokerage accounts. Here are several investment account types that can help significantly to reduce the tax bite. They include:

  • Individual retirement accounts (IRAs) – A traditional IRA allows a saver to deduct contributions to the account from current income, within dollar limits, reducing current federal income taxes and deferring taxes on future growth of the investment.
  • Other retirement accounts –  401(k) and 403(b) accounts also let savers reduce current income and defer taxes on future gains. Roth IRAs are for after-tax funds. By paying taxes now, investors can make future withdrawals free of federal income taxes.
  • 529 plans – These college funding plans let parents, grandparents and students make tax-sheltered deposits that can grow free of federal income tax and be withdrawn tax-free to pay eligible education expenses.
  • Health savings accounts (HSAs) – An HSA offers triple-tax benefits: Current deposits may be deductible from current income; investment gains can be free of income tax; and future withdrawals are also tax free when used to pay eligible medical expenses.

Tax Efficient Investments

Thirdly, tax-aware investors can choose from specific investments that provide tax benefits. They include:

  • Municipal bonds – Income from municipal bonds is generally free from federal incomes and often state and local taxes.
  • Tax-managed funds – Some mutual funds are managed with the specific objective of reducing tax impacts by, among other methods, purchasing municipal bonds and reducing turnover.
  • Passively managed funds – Exchange-traded funds (ETFs) and index mutual funds that passively track an index are naturally tax-efficient because managers do not buy and sell securities as often as actively managed funds. This reduces the tax obligations created by short-term capital gains on investments held less than a year.

The Bottom Line

Tax Time graphicWhile making investment decisions strictly on the basis of tax effects is not recommended, considering the impact of taxes is widely practiced and can help investors achieve financial goals. Tax efficient investing strategies, accounts and investments can potentially help investors achieve improved after-tax gains. They do this by taking advantage of long-term capital gains tax treatments, employing tax-advantaged account types such as IRAs and 401(k)s, and selecting investments that avoid or reduce taxes, such as municipal bonds.

Tips on Investing

  • Tax efficient investing requires up-to-date knowledge of tax laws and investment characteristics. Qualified and experienced financial advisors are well-equipped to help investors make sure their choices won’t cost more in taxes than necessary. Finding such a person doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • The federal income tax system is progressive, so the rate of taxation increases as income increases. A free income tax calculator can be a valuable tool as you boost the tax efficiency of your portfolio.

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