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No one enjoys handing money over to the IRS, but everyone is responsible for paying taxes. Taking advantage of tax-efficient investing options can help you reap the benefits of certain tax breaks, especially if you fall into a higher tax bracket.
Here we explore some considerations you can keep in mind to potentially minimize your tax burden.
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Choose tax-efficient accounts for your assets
Regular brokerage accounts won’t help you minimize taxes — though tax-favorable investments can be held within them to help reduce tax ramifications (more on that below) — but retirement accounts, 529s and health savings accounts, or HSAs, can provide tax benefits.
401(k)s and traditional IRAs. These retirement accounts provide you with tax-deferred growth. Account contributions to 401(k)s and traditional IRAs are pre-tax, so you benefit from immediate tax deductions and tax-deferred growth but will be responsible for paying income taxes on distributions in the future.
529s. Though contributions may not be deductible, earnings grow tax-free and withdrawals are tax-free when used for qualified educational expenses.
Roth IRAs and Roth 401(k)s. Roths are tax-exempt accounts. Contributions are made with after-tax dollars, so there’s no immediate tax deduction. However, the account grows tax-free and future distributions are free from tax as well. If you don't meet the Roth IRA income limit, so you're ineligible to contribute, consider getting in through a backdoor Roth IRA.
Health savings accounts, or HSAs. For those using a high-deductible health insurance plan, taking advantage of an HSA provides triple tax advantages — contributions are deductible, your account grows tax-deferred and withdrawals are tax-free when used for qualified medical expenses.
Irrevocable trusts. Removing assets from your personal estate by setting up an irrevocable trust can shield you from estate tax and gift tax consequences.
Most retirement accounts have an annual contribution limit, but saving as much as you can or maxing out these accounts can provide a chunk of your investments with tax-deferred or tax-exempt benefits.
What investments to put where
Being deliberate about which types of investments you place within certain account types is important. Housing your more active or less tax-efficient investments in retirement accounts shelters them from capital gains taxes. And placing your less actively traded or more tax-efficient investments in taxable brokerage accounts reduces your tax liability as these assets should generate less capital gains and help minimize the impact of taxes on that account.
Caveat: Your asset location strategy should work hand-in-hand with an appropriate asset allocation strategy.
Identify tax-efficient investments
Some investments are more tax-favorable than others. Again, thoughtful consideration about the investments used within each account plays a key role in tax-efficient investing.
Mutual funds vs. index funds and exchange-traded funds
Often, investors purchase mutual funds to gain access to a diversified mix of securities, such as stocks, bonds or both, through one investment vehicle. However, active mutual funds frequently trade in and out of different positions. While active trading can help a fund make money, the high turnover can also generate taxable capital gains that are passed through to you, the investor. (There are some active mutual funds that are purposefully managed to reduce investors’ tax liabilities, but the added tax benefits often come with a higher price tag.)
Passively managed mutual funds, such as index funds, often mimic an underlying benchmark index and are generally more tax-efficient than active mutual funds because index funds usually buy and hold their positions and thus have lower turnover.
An exchange-traded fund, or ETF, also offers access to a broad selection of securities in one investment. Similar to passive or index mutual funds, most ETFs simulate an underlying benchmark index, but ETFs are structured differently from mutual funds, making them more tax-efficient due to lower turnover while also avoiding capital gains distributions on individual securities within the fund.
» Which is right for you? ETFs vs. index funds
Municipal and Treasury bonds
Municipal bonds are generally exempt from federal taxes, and purchasing tax-free munis in the state in which you reside can also provide state and local tax exemption. Since other bonds may not be as tax-efficient as tax-free municipal bonds, it can make sense to hold municipal bonds in taxable brokerage accounts while placing other bonds in tax-advantaged accounts.
Treasury bonds also come with some tax advantages as interest income earned is state and local tax-free. However, you'll be responsible for taxes at the federal level, and the interest earned is taxed at income tax rates rather than at lower capital gains rates.
Other asset classes or types of investments can also be beneficial on the tax front.
Real estate. Investing in real estate is popular as you can take advantage of tax deductions and write-offs, favorable capital gains tax treatment and potentially some other incentives.
Life insurance. Proceeds from life insurance, both permanent and term, usually are paid out sans income tax. Permanent life insurance policies accumulate cash value while deferring taxes, and policyholders can borrow up to the cost basis, or the sum of the premiums paid in, of their life insurance policy without being subject to any tax payments.
Annuities. As investment products sold by insurance companies, annuities benefit from tax-deferred growth until distributions begin.
Employ tax-efficient investing strategies
Beyond asset location and investment selection, you can use other strategies in an effort to pare back your tax burden.
Managing capital gains
If you are considering selling an investment, especially one that has made a gain, pay attention to the length of time you’ve held the investment and the size of that gain. You’ll be responsible for capital gains taxes on the gain, and those tax rates are determined by the length of time you’ve owned the investment.
Short-term capital gains tax applies when selling an investment held for one year or less; these gains are taxed at ordinary income tax rates of up to 37%. Investments held for longer than a year trigger long-term capital gains tax, which are 0%, 15% or 20% depending on your filing status and income level. If you can wait to get past that one-year mark before selling investments with capital gains, you’ll likely pay a lower tax rate.
If some of your investments generated a loss, those losses could come in handy to offset your gains. Selling losing investments you no longer want to hold and capturing their losses allows you to offset any capital gains tax you might owe on other investments sold for a gain that year. Tax-loss harvesting can be an effective way to reduce your tax bill, but there are rules to be aware of, such as avoiding wash sales (when you sell a security to take a loss and then buy the same, or a very similar, security back within 30 days).
» MORE: How to reduce capital gains tax
As mentioned above, mutual funds can trigger capital gain distributions that are passed along to you, typically in December. As fund managers trade, trim and add to various positions, the fund can generate capital gains and income distributions. Sometimes the fund will have enough losses to offset the gains, but other times, any outstanding gains must be distributed to and are taxable for shareholders. Mutual fund companies publish estimates of capital gain distributions toward the end of the year. If these capital gains distributions are significant, you can consider selling out of that fund and moving into another mutual fund or ETF before the distribution hits.
Giving to charity
Giving to others can also give back by way of a tax deduction. Cash donated to charity can reduce your taxable income, but gifting highly appreciated marketable securities, real estate or private business interest can provide even greater tax advantages. This is because those highly appreciated securities would have generated large capital gains had you sold them instead. By gifting these appreciated securities in lieu of cash donations, you receive the tax deduction and also benefit from avoiding taxes on those capital gains.
» Feeling philanthropic: Consider charitable giving and tax strategies
In retirement, retirees with traditional IRAs must eventually take required minimum distributions, or RMDs, from their IRA and pay taxes to the federal government. For some individuals, taking RMDs can produce the negative tax effect of moving into a higher tax bracket.
Individuals who don’t need these distributions to cover daily living expenses and would rather not get hit with additional taxes can take advantage of qualified charitable deductions. QCDs allow you to give your RMDs directly to charity (up to $100,000 each year), and you can reduce your taxable income by the gifted amount in return.
Creating tax diversification and flexibility
Another way to manage taxes in retirement is by building flexibility into your investments. By using Roth IRA accounts, QCDs, deferred compensation and other vehicles with varied tax treatments, you can assess your tax situation each year, strategically withdrawing income and making tax-efficient decisions to reduce your tax burden.
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How to get started
If tackling investing while weighing the tax consequences makes your head spin, or you want a second opinion to ensure you’re maximizing tax benefits, consulting a financial advisor and a tax advisor can help. They can assess your situation and inform you on whether any changes should be made to enhance the tax efficiency of your investments.
As a seasoned financial advisor specializing in tax-efficient investing strategies, I've spent years navigating the complexities of the tax code to help clients minimize their tax burdens while maximizing their investment returns. Let's break down the key concepts mentioned in the article you provided:
Tax-efficient Accounts: The article discusses various tax-advantaged accounts like 401(k)s, traditional IRAs, Roth IRAs, 529s, HSAs, and irrevocable trusts. Each of these accounts offers different tax benefits, such as tax-deferred growth, tax-free withdrawals, or tax deductions for contributions.
Asset Location Strategy: Placing investments strategically across different account types to optimize tax efficiency is crucial. For example, holding tax-inefficient investments in retirement accounts can shield them from immediate tax implications, while placing tax-efficient investments in taxable brokerage accounts can minimize overall tax liability.
Tax-efficient Investments: Certain investments are more tax-favorable than others. For instance, index funds and ETFs tend to be more tax-efficient compared to actively managed mutual funds due to lower turnover and fewer capital gains distributions. Municipal bonds and Treasury bonds also offer tax advantages, with municipal bonds providing tax-free interest income at the federal level and potentially at the state and local levels.
Managing Capital Gains: Understanding the tax implications of selling investments is crucial. Holding investments for longer periods can qualify for lower long-term capital gains tax rates, while harvesting tax losses can offset gains and reduce tax liabilities. Additionally, being mindful of capital gain distributions from mutual funds can help in tax planning.
Charitable Giving and Tax Strategies: Donating appreciated securities to charity can offer significant tax advantages by avoiding capital gains taxes while still receiving a tax deduction for the fair market value of the donated assets. Qualified Charitable Distributions (QCDs) from retirement accounts can also provide tax benefits for retirees while supporting charitable causes.
Tax Diversification and Flexibility: Building flexibility into investment portfolios by utilizing a mix of tax-deferred, tax-free, and taxable accounts allows for strategic tax planning, especially in retirement. This approach enables investors to adapt to changing tax situations and optimize tax efficiency over time.
By implementing these strategies and staying informed about changes in tax laws and investment regulations, investors can effectively manage their tax liabilities and enhance their overall financial well-being. If you need personalized advice or assistance with tax-efficient investing, consulting with a qualified financial advisor and tax professional is recommended.