Skip to main content

Six Tax-Efficient Investing Strategies

December 07, 2020

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.  

Schedule a No-Obligation Discovery Call

Managing your wealth is a very personal subject, one we should discuss in a more personal setting.