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Six Tax-Efficient Investing Strategies

Present and Future Tax Liabilities Should Be Considered in Any Investment Decision

Six Tax-Efficient Investing Strategies

There is so much to consider when making investment decisions, especially when you’re working toward meeting specific short- and long-term financial goals. This is certainly true of the tax implications of your investment strategy, as taxes can reduce your investment returns from year to year and jeopardize your ability to achieve your goals. This is especially true if you fall into a higher federal income tax bracket, making it even more important to consider the impact of taxes when making any changes to your investments. While you should always consult with a tax professional regarding your unique investment and tax scenarios, the following six tax-efficient investing strategies may be beneficial to your finances.

Strategy #1: Contribute to Tax-Efficient Accounts

If you’re eligible to contribute to tax-efficient retirement accounts, like traditional IRAs, Roth IRAs, and 401(k) accounts, you can help to reduce your current and future taxes. In the present, for instance, your traditional IRA contributions are tax-deductible depending on your income (subject to a dollar limit), and your 401(k) contributions are pre-tax and will reduce your current taxable income (subject to contribution limits). For the future, traditional IRAs and 401(k)s offer you the potential for tax-deferred growth, while Roth accounts give you tax-free growth potential.  Learn more about Roth IRAs by reading this related blog post.

Strategy #2: Diversify the Types of Accounts You Maintain

Mixing and matching your income sources in retirement through a combination of investment account types can help you minimize your tax burden. This is true because different types of accounts offer disparate tax treatments. For instance, brokerage accounts offer you taxable growth potential, while traditional IRAs offer you tax-deferred growth potential, and Roth IRAs offer growth potential that won’t be taxed as long as you meet the requirements for qualified distributions.

Here’s an example of how using a combination of accounts can be beneficial:

If you are eligible to take tax deductions in retirement, you won’t be able to do so unless you have taxable income. Withdrawals from a traditional IRA count as taxable income, so your strategy could be to withdraw just enough to offset your eligible deductions. You could draw the remainder of the income you need from your Roth IRA account. Those qualified distributions from your Roth IRA are income-tax-free, therefore do not increase your tax bills during retirement.

This is just one example of how splitting up your contributions to different account types now can help you reduce your future tax burden. This type of planning can be incredibly useful. However, it is only possible to enjoy these tax benefits in retirement if you start taking steps to diversify your contributions right now.


SEE ALSO: Four Times You Should Consider a Roth Conversion


Strategy #3: Make Tax-Efficient Investments

Did you know that specific investments can carry tax benefits? One example is income earned from municipal bonds, which is always federally tax-free (and even state and local tax-free if you buy municipal bonds in your resident state). Other examples of tax-smart investment choices include tax-managed mutual funds, where the fund managers work purposefully for tax-efficiency. You can also choose to invest in index funds and exchange-traded funds (ETFs) that passively track a target index. Because the securities in the index funds are not traded as frequently as the actively managed mutual funds, they generate lower short-term capital gains distributions.  

Strategy #4: Hold Your Investments in the Right Account Type

You can’t take full advantage of tax-efficient investments unless you’re also holding them in accounts matched to the appropriate tax treatment. This way, you can truly realize the full potential of the tax benefits you’re seeking – without accidentally increasing your tax liability.

Here are two examples:

Investments that generate taxable income are often better held in tax-deferred or tax-free accounts (401(k) plan, traditional IRA, Roth IRA, and Health Savings Account). So, you may want to utilize a traditional IRA for things like taxable corporate bonds or stock funds with high turnover to maximize your potential tax benefit. You do not need to report realized gains, dividends, and interest income from tax-deferred accounts each year on tax returns until distributions.

The tax-efficient investments such as municipal bonds, ETFs, or tax-managed mutual funds are often best suited in taxable brokerage accounts (individual account, joint account, or trust account). ETFs are more tax-efficient because of the structure that is different than mutual funds.  You can use ETFs in both retirement accounts and taxable accounts for their liquidity and low-cost benefits.  Holding ETFs in taxable accounts provides an additional tax benefit.  You also have easy access to your taxable accounts before age 59.5 without penalties.

When you’re using this Asset Location strategy, ensure your decisions about where to hold various investments are consistent with your overall asset allocation strategy.  Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash.

Strategy #5: Avoid Unnecessary Capital Gains by Holding Investments Longer

First, it’s important to note that it is usually not worth holding onto a stock you feel ready to sell simply to avoid taxes, but there’s one notable exception. Consider this: Gains on stocks held for a year or less are short-term capital gains and are taxed at ordinary income rates, but gains on stocks held longer than one year are taxed at the long-term capital gains rate. So, it could make sense to delay selling appreciated stocks until they qualify for capital gains treatment if your stock’s holding period is nearly one year.  .For 2020, a single filer pays 0% on long-term capital gains if you have an income of $40,000 or less; 15% if you have an income of $441,450 or less, and 20% if your income is greater than $441,450.  Work with your tax advisor to ensure you use this strategy appropriately.


SEE ALSO: Understanding the ‘Rich Person Roth’


Strategy #6: Use Your Investment Losses to Offset Your Gains

This strategy is often referred to as “tax-loss harvesting.” It means using any investment losses you may incur to offset your gains each year, and it can help you reduce your income tax liability. If your investment losses exceed your gains, you are permitted to use them to offset up to $3,000 of earned income annually, as well. Plus, you can carry any additional losses forward to future tax years. If you’re a higher-earning investor, this can be an especially valuable strategy.

Final Thoughts on Tax-Efficient Investing Strategies

While the strategies above can be helpful, tax-efficient investing should not supersede your overall investment strategy. It’s an important consideration and one that can help you choose among various investment options, but you should also think about how each of your investments can help you reach your goals around diversification, liquidity, and risk level.

As always, when making any decisions that could impact your taxes, it’s wise to consult with a professional tax advisor. Tax laws change regularly, and every investors’ situation is unique, so it’s important to have experts in your corner to help you make wise and disciplined decisions toward reaching your financial goals.

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