A Guide to Tax-Efficient Investing
As the saying goes: It’s not how much you earn, it’s how much you keep. And when you make money from your investments you need to consider the impact taxes might have on your earnings.
Fortunately, there are a range of tax-efficient investment strategies that can help minimize the bite that taxes take out of your returns.
What is tax-efficient investing, and how does it work? By understanding the tax implications of different types of accounts, as well as the types of investments you choose (e.g. stocks, bonds, mutual funds), you can determine the most tax-efficient strategies for your portfolio.
The Importance of Tax-Efficient Investing
Investing comes with an assortment of costs, and the taxes you pay on investing profits can be one of the biggest. By learning how to be a more tax-efficient investor, you may be able to keep more of what you earn.
The Impact of Taxes on Returns
Investment tax rules are complicated. Profits from many stock and bond investments are taxed at the capital gains rate; but some bonds aren’t taxed at all. Qualified dividends are taxed in one way; non-qualified dividends another. Investments in a taxable account are treated differently than those in a tax-advantaged account.
And, of course, there is the process of applying investment losses to gains in order to reduce your taxable gains — a strategy known as tax-loss harvesting.
In addition, the location of your investments — whether you hold them in a taxable account or a tax-advantaged account (where taxes can be deferred, or in some cases avoided) — also has an impact on your returns. In a similar way, you can refocus your charitable giving strategy to be tax efficient as well.
Knowing the ins and outs of investment taxes can help you establish a tax-efficient strategy that makes sense for you.
💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.
Types of Tax-Efficient Accounts
Investment accounts can generally be divided into two categories based on how they’re taxed: taxable and tax-advantaged.
Taxable Accounts
In order to understand tax-deferred and tax-exempt accounts, it helps to first understand taxable accounts, e.g. brokerage accounts. A taxable brokerage account has no special tax benefits, and profits from the securities in these accounts may be taxed according to capital gains rules (unless other rules apply).
Taxable accounts can be opened in the name of an individual or trust, or as a joint account. Money that is deposited into the investment account is post-tax, i.e. income taxes have already been paid or will be paid on those funds (similar to the money you’d put into a checking or savings accounts).
Taxes come into play when you sell investments in the account and make a profit. You may owe taxes on the gains you realize from those investments, as well as earned interest and dividends.
With some securities, like individual stocks, the length of time you’ve held an investment can impact your tax bill. Other investments may generate income or gains that require a different tax treatment.
For example:
• Capital gains. The tax on an investment gain is called capital gains tax. If an investor buys a stock for $40 and sells it for $50, the $10 is a “realized” gain and will be subject to either short- or long-term capital gains tax, depending on how long the investor held the investment.
The short-term capital gains rate applies when you’ve held an investment for a year or less, and it’s based on the investor’s personal income tax bracket and filing status — up to 37%.
The long-term capital gains rate, which is generally 0%, 15%, or 20% (depending on your income), applies when you’ve held an investment for more than a year.
• Interest. Interest that’s generated by an investment, such as a bond, is typically taxed as ordinary income. In some cases, bonds may be free from state or local taxes (e.g. Treasuries, some municipal bonds).
But if you sell a bond or bond fund at a profit, short- or long-term capital gains tax could apply.
• Dividends. Dividends are distributions that may be paid to investors who hold certain dividend stocks. Dividends are generally paid in cash, out of profits and earnings from a corporation — and can be taxed as short- or long-term capital gains within a taxable account.
Recommended: How Do Dividends Work?
But the terms are different when it comes to tax-advantaged accounts.
Tax-Advantaged Accounts
Tax-advantaged accounts fall into two categories, and are generally used for long-term retirement savings.
Tax-Deferred Retirement Accounts
A 401(k), 403(b), traditional IRA, SEP IRA, and Simple IRA fall under the tax-deferred umbrella, a tax structure typical of retirement accounts. They’re considered tax efficient for a couple of reasons.
• Pre-tax contributions. First, the money you contribute to a tax-deferred account is not subject to income tax; you owe taxes when you withdraw the funds later, e.g. in retirement. Thus the tax is deferred.
This means the amount you contribute to a tax-deferred account for a given year can be deducted from your taxable income, potentially reducing your tax bill for that year.
Speaking hypothetically: If your taxable income for a given year is $100,000, and you’ve contributed $5,000 to a traditional IRA or SEP IRA, you would deduct that contribution and your taxable income would be $95,000. You wouldn’t pay taxes on the money until you withdrew that funds later, likely in retirement.
• Tax-free growth. The money in a tax-deferred retirement account (e.g. a traditional IRA) grows tax free. Thus you don’t incur any taxes until the money is withdrawn.
• Potentially lower taxes. By deducting the contribution from your taxable income now, you may avoid paying taxes at your highest marginal tax rate. The idea is that investors’ effective (average) tax rate might be lower in retirement than their highest marginal tax rate while they’re working.
Tax-Exempt Accounts
Typically known as Roth accounts — e.g. a Roth IRA or a Roth 401(k) — allow savers to deposit money that’s already been taxed. These funds, plus any gains, then grow tax free, and qualified withdrawals are also tax free in retirement.
Because contributions to Roth accounts are made post-tax, there is also more flexibility on when the money can be withdrawn. You can withdraw the amount of your contributions tax and penalty free at any time. However earnings on those investments may incur a penalty for early withdrawal, with some exceptions.
Recommended: What Is the Roth IRA 5-Year Rule?
Tax Benefits of College Savings Plans
529 College Savings Plans are a special type of tax-exempt account. The contributions and earnings in these accounts can be withdrawn tax free for qualified education expenses. In some cases you may be able to deduct your contributions from your state taxes, but the rules vary from state to state.
While you can invest the money in these accounts, they are limited in scope so aren’t generally considered one of the broader investment account categories.
Tax-Efficient Accounts Summary
As a quick summary, here are the main account types, their tax structure, and what that means for the types of investments you might hold in each.
• Generally you want to hold more tax-efficient investments in a taxable account.
• Conversely, you may want to hold investments that can have a greater tax impact in tax-deferred and tax-exempt accounts, where investments can grow tax free.
| Types of Accounts | When Taxes Apply | Investment Implications |
|---|---|---|
| Taxable (e.g. brokerage or investment account) |
Investors deposit post-tax funds and owe taxes on profits from securities they sell, and from interest and dividends. | Investments with a lower tax impact make sense in a taxable account (e.g. long-term stocks, municipal and Treasury bonds). |
| Tax-deferred (e.g. 401(k), 403(b), traditional, SEP, and Simple IRAs) | Investors contribute pre-tax money, but owe taxes on withdrawals. | Investments grow tax free until funds are withdrawn, giving investors more tax flexibility when choosing securities. |
| Tax-exempt (e.g. Roth 401(k), Roth IRA) |
Investors deposit post-tax funds, and don’t owe taxes on withdrawals. | These accounts offer the most tax flexibility as investments grow tax free and investors withdraw the money tax free. |
The Tradeoffs of Tax-Free Growth
Because of the advantages tax-deferred accounts offer investors, there are restrictions around contribution limits and the timing (and sometimes the purpose) of withdrawals. Taxable accounts are generally free of such restrictions.
• Contribution limits. The IRS has contribution limits for how much you can save each year in most tax-advantaged accounts. Be sure to know the rules for these accounts, as penalties can apply when you exceed the contribution limits.
• Income limits. In order to contribute to a Roth IRA, your income must fall below certain limits. (These caps don’t apply to Roth 401(k) accounts, however.)
• Penalties for early withdrawals. For 401(k) plans and traditional as well as Roth IRAs, there is a 10% penalty if you withdraw money before age 59 ½, with some exceptions.
• Required withdrawals. Some accounts, such as traditional, SEP, and Simple IRAs require that you withdraw a minimum amount each year after age 72 (or 73 if you turned 72 after Dec. 31, 2022). These are known as required minimum distributions (RMDs).
The rules governing RMDs are complicated, and these required withdrawals can have a significant impact on your taxable income, so you may want to consult a professional in order to plan this part of your retirement tax plan.
When choosing the location of different investments, be sure to understand the rules and restrictions governing tax-advantaged accounts.
Choosing Tax-Efficient Investments
Next, it is helpful to know that some securities are more tax efficient in their construction, so you can choose the best investments for the type of account that you have.
For example, ETFs are considered to be more tax efficient than mutual funds because they don’t trigger as many taxable events. Investors can trade ETFs shares directly, while mutual fund trades require the fund sponsor to act as a middle man, activating a tax liability.
Here’s a list of some tax-efficient investments:
• ETFs: These are similar to mutual funds but more tax efficient due to their construction. Also, most ETFs are passive and track an index, and thus tend to be more tax efficient than their actively managed counterparts (this is also true of index mutual funds versus actively managed funds).
• Treasury bonds: Investors will not pay state or local taxes on interest earned via U.S. Treasury securities, including Treasury bonds. Investors do owe federal tax on Treasury bond interest.
• Municipal bonds: These are bonds issued by local governments, often to fund municipal buildings or projects. Interest is generally exempt from federal taxes, and state or local taxes if the investor lives within that municipality.
• Stocks that do not pay dividends: When you sell a non-dividend-paying stock at a profit, you’ll likely be taxed at the long-term capital gains rate, assuming you’ve held it longer than a year. That’s likely lower than the tax you’d pay on ordinary dividends, which are generally taxed as income at your ordinary tax rate.
• Index funds vs. actively managed funds: Generally speaking, index funds (which are passively managed) have less churn, and lower capital gains. Actively managed funds are the opposite, and may incur higher taxes as a result.
Note that actively trading stocks can have additional tax implications because more frequent trades, specifically those that fall into the short-term capital gain category, incur a higher tax rate on gains.
Typically, tax consequences will vary from person to person. A tax professional can help navigate your specific tax questions.
Estate Planning and Charitable Giving
Another important aspect of tax-efficient investing is adjusting your estate plan and establishing a strategy for charitable bequests. Because both these areas — inheritances and philanthropy — can be extremely complex taxwise, it may be wise to consult with a professional.
Taxes and Estate Planning
There are a number of ways to structure inheritances in a tax-efficient manner, including the use of gifts, trusts, and other vehicles. With a sophisticated estate-planning strategy, taxes can be minimized for the donor as well as the receiver.
For example, while there is a federal estate tax, there is no federal inheritance tax. And only six states tax your inheritance as of 2024 (Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania). Iowa is phasing out their inheritance tax for deaths after 2025.
Yet your heirs may owe capital gains if you bequeath assets that then appreciate. But if you leave stock to your heirs, they can enjoy a step-up in cost basis based on when they inherited the stock, so they’d be taxed on gains from that time, not from the original price at purchase.
Tax Benefits of Charitable Contributions
Tax-efficient charitable giving is possible using a variety of strategies and accounts. For example a charitable remainder trust can reduce the donor’s taxable income, provide a charity with a substantial gift, while also creating tax-free income for the donor.
This is only one example of how charitable gifts can be structured as a win-win on the tax front. Understanding all the options may benefit from professional guidance.
💡 Quick Tip: Newbie investors may be tempted to buy into the market based on recent news headlines or other types of hype. That’s rarely a good idea. Making good choices shouldn’t stem from strong emotions, but a solid investment strategy.
Advanced Tax-Efficient Strategies
It may also be possible to minimize taxes by incorporating a few more strategies as you manage your investments.
Asset Location Considerations
As noted above, one method for minimizing the tax impact on your investments is through the careful practice of asset location. A well-considered combination of taxable, tax-deferred, and tax-exempt accounts can help mitigate the impact of taxes on your investment earnings.
For example, with some investment accounts — such as IRAs and 401(k)s — your tax bracket can have a substantial impact on the tax you’ll pay on withdrawals. Having alternate investments to pull from until your tax bracket is more favorable is a smart move to avoid that excess tax.
Also, with multiple investment accounts, you could potentially pull tax-free retirement income from a Roth IRA, assuming you’re at least 59 ½ and have held the account for at least five years (also known as the 5-year rule). and leave your company-sponsored 401(k) to grow until RMDs kick in.
Having a variety of investments spread across account types gives you an abundance of options for many aspects of your financial plan.
• Need to cover a sudden large expense? Long-term capital gains are taxed at a significantly lower rate than short-term capital gains, so consider using those funds first.
• Want to help with tuition costs for a loved one? A 529 can cover qualified education costs at any time, without incurring taxes or a penalty.
• Planning to leave your heirs an inheritance? Roth IRAs are tax free and transferrable. And because your Roth IRA does not have required distributions (as a traditional IRA would), you can allow the account to grow until you pass it on to your heir(s).
Tax-Loss Harvesting
Within taxable accounts, there may be an additional way to minimize some of the tax bill created by selling profitable investments: tax-loss harvesting. This advanced move involves reducing the taxes from an investment gain with an investment loss.
For example, an investor wants to sell a few investments and the sale would result in $2,000 in capital gains. Tax-loss harvesting rules allow them to sell investments with $2,000 in total capital losses, effectively canceling out the gains. In this scenario, no capital gains taxes would be due for the year.
Note that even though the investor sold the investment at a loss, the “wash sale” rule prevents them from buying back the same investment within 30 days after those losses are realized. This rule prevents people from abusing the ability to deduct capital gain losses, and applies to trades made by the investor, the investor’s spouse, or a company that the investor controls.
Because this strategy involves the forced sale of an investment, many investors choose to replace it with a similar — but not too similar — investment. For example, an investor that sells an S&P 500 index fund to lock in losses could replace it with a similar U.S. stock market fund.
Recommended: What Are the Benefits of Tax Loss Harvesting?
Tax-Loss Carryover
Tax-loss harvesting rules also allow an investor to claim some of that capital loss on their income taxes, further reducing their annual income and potentially minimizing their overall income tax rate. This can be done with up to $3,000 in realized investment losses, or $1,500 if you’re married but filing separately.
Should your capital losses exceed the federal $3,000 max claim limit ($1,500 if you’re married and filing separately), you have the option to carry that loss forward and claim any amounts excess of that $3,000 on your taxes for the following year.
For example, if you have a total of $5,000 in capital losses for this year, by law you can only claim $3,000 of those losses on your taxes. However, due to tax-loss carryover, you are able to claim the remaining $2,000 as a loss on your taxes the following year, in addition to any capital gains losses you happen to experience during that year. This in turn lowers your capital gains income and the amount you may owe in taxes.
Roth IRA Conversions
It’s also possible in some cases to convert a traditional IRA to a Roth IRA. This is a complicated strategy, with pluses and minuses on the tax front.
• By converting funds from a traditional IRA to a Roth, you will immediately owe taxes on the amount you convert. The conversion amount could also push you into a higher tax bracket; meaning, you’d potentially owe more in taxes.
• Unlike funding a standard Roth IRA, there is no income limit for doing a Roth conversion, nor is there a cap on how much can be converted.
• Once the conversion is complete, you would reap the benefits of tax-free withdrawals from the Roth IRA in retirement.
• According to the 5-year rule, if you’re under age 59 ½ the funds that you convert to a Roth IRA must remain in your account for at least five years or you could be subject to a 10% early withdrawal penalty.
Final Thoughts on Tax-Efficient Investing
Given the impact of investment taxes on your returns, it makes sense to consider all the various means of tax-efficient investing. After all, not only are investment taxes an immediate cost to you, that money can’t be invested for further growth.
Key Strategies Recap
Once you understand the tax rules that govern different types of investment accounts, as well as the tax implications of your investment choices, you’ll be able to create a strategy that minimizes taxes on your investment income for the long term. Ideally, investors should consider having a combination of tax-deferred, tax-exempt, and taxable accounts to increase their tax diversification. To recap:
• A taxable account (e.g. a standard brokerage account) is flexible. It allows you to invest regardless of your income, age, or other parameters. You can buy and sell securities, and deposit and withdraw money at any time. That said, there are no special tax benefits to these accounts.
• A tax-deferred account (e.g. 401(k), traditional IRA, SEP IRA, Simple IRA) is more restrictive, but offers tax benefits. You can deduct your contributions from your taxable income, potentially lowering your tax bill, and your investments grow tax free in the account. Your contributions are capped according to IRS rules, however, and you will owe taxes when you withdraw the money.
• A tax-exempt account (e.g. a Roth IRA or Roth 401(k)) is the most restrictive, with income limits as well as contributions limits. But because you deposit money post-tax, and the money grows tax free in the account, you don’t owe taxes when you withdraw the money in retirement.
Further Learning in Tax-Smart Investing
Being smart about tax planning applies to the present, to educational expenses, to the future (in terms of taxes you could owe in retirement), and to your estate plan and your heirs as well. Maximizing your tax-efficient strategies across the board can make a significant difference over time.
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