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A Guide to Tax-Efficient Investing

November 04, 2020 · 7 minute read

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A Guide to Tax-Efficient Investing

When investing, the ultimate goal is to find ways to have your money make you money. Really, that’s it! Though investing strategy can become complicated, the purpose of the endeavor is as simple as can be.

Any time money making is involved, it’s generally smart to consider how taxes might be affected. Just as there are rules regarding the taxes owed on earned income, there are rules for income earned through investing.

What is Tax-Efficient Investing?

Using some simple strategies for tax-efficient investing could potentially save an investor quite a bit of cash.

What is tax-efficient investing? Tactics that aim to reduce or eliminate the tax bill generated when an investment is profitable. Tax-efficient investment strategies keep more money in the pockets of investors—or rather, working for them, with growth compounding in the investment markets.

Typically, these strategies fall into one of three categories: account types, investment types, and ways to minimize the impact of selling investments that could generate a tax bill. Read on for a description of each of the major tax-efficient investing strategies and who they may make the most sense for.

Tax-Efficient Investing Strategies: Accounts

Accounts can be split into three major categories of taxation: tax-deferred, tax-exempt, and taxable. Tax-deferred and tax-exempt varieties are generally considered more tax advantageous than a taxable account for long-term investing. Tax-deferred and tax-exempt accounts are generally retirement accounts.

In order to understand tax-deferred and tax-exempt accounts, it helps to first understand taxable accounts. In the universe of investing, these are often called brokerage accounts or investment accounts.

Taxable Accounts

A brokerage account is a standard-issue investment account. “Investment account” is another common catchall for an account with no special taxation benefits. For example, it is possible to open an investment account with an online trading platform like SoFi Invest.®

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; income taxes have already been paid (or will be paid). In this way, it is just like a checking or savings account. This can be thought of as “normal” taxation.

When money within a taxable account is invested, taxes are applied to the money earned via investing. The two major flavors of taxation here are on 1) investments sold for a profit and 2) interest earned.

The first of the two is called capital gains tax. Capital gains tax applies to money earned by selling an investment at a profit. For example, if an investor buys a stock for $10 and sells it for $50, the $40 is a “realized” gain and will be subject to capital gains tax. The tax rate will depend on how long the investment was held—more or less than a year—and the investor’s personal income tax rate.

Interest that is generated by an investment, such as a bond, is typically taxed as ordinary income. If regular income is produced by investments, it is reasonable to expect a tax bill every year.

Next, compare this tax structure to tax-deferred and tax-exempt accounts, both of which are considered to be more tax-efficient places to invest for the long term.

Tax-Deferred Accounts

A 401(k), 403(b), Traditional IRA, SEP IRA, and Simple IRA fall under the tax-deferred umbrella, the taxation typical of retirement accounts.

Just as it sounds, taxes are deferred until later, ideally in retirement. Instead of paying income taxes when the money is contributed to the investment account, the investor pays taxes on the money when it is pulled out of the account. This way, investors can deduct the contribution from taxable income, which may help them avoid paying taxes at their highest marginal tax rate. In theory, investors’ effective (average) tax rate will be lower in retirement than their highest marginal tax rate while they are working.

That said, it is hard to bank on this particular tax advantage, as tax rates could change, and while most people tend to fall into a lower tax bracket when they retire, that’s not always the case.

There’s another tax benefit to investing within a tax-deferred retirement account: no capital gains tax or taxes on interest earned. Within retirement accounts, investments are allowed to grow without incurring taxes. That’s why you’ll sometimes hear a retirement account referred to as a “tax shelter,” as investments are allowed to grow free from the watch of Uncle Sam.

Because the IRS is throwing investors a bone with tax-deferred accounts, there are some rules about how the money can be used. For IRAs, there is a 10% penalty to take the money out before age 59½, which is what the IRS has determined is retirement age. (There are some exceptions to this rule.) At age 72, investors must begin to take withdrawals, called required minimum distributions.

The IRS sets contribution limits for tax-deferred accounts. For example, the maximum contribution for a 401(k) was $19,500 in 2020. (An employer’s match program is not counted toward the contribution limit.)

Tax-Exempt Accounts

The second style of retirement account is tax-exempt accounts: the Roth IRA and Roth 401(k).

Money contributed to a Roth account has already been subjected to an investor’s income tax rate. Therefore, when the money is withdrawn in retirement, it will not be subject to income taxes. Income taxes are not deferred. (Said in tax-filing lingo, contributions to a tax-exempt account are not tax-deductible.)

Roth accounts provide a place to grow investments free from taxation on investment gains and interest.

Because contributions to Roth accounts are made post-tax, there is more flexibility on when it can be withdrawn. (Said another way, an investor paid taxes on that money, so that money is theirs.) Money earned through investing adheres to a different set of rules for withdrawal, including a penalty for early withdrawal. For example, if an investor contributed $5,000, but that amount grew to $7,000, only the $2,000 in investment gains could be penalized for early withdrawal.

It’s possible to earn too much to be eligible to contribute to a Roth IRA. At $124,000 for a single person and $196,000 for a couple filing jointly, access to a Roth IRA begins to phase out.

Roth IRA accounts had an annual contribution maximum of $6,000 in 2020, with catch-up contributions available to investors over 55. An investor can contribute up to $19,500 to a Roth 401(k).

A Roth account may make sense for an investor who has a low overall tax rate, paying income taxes now. Because of this, Roth accounts tend to be popular with young investors. Others may simply prefer to pay income taxes now and not have to worry about the tax bill in retirement.

Investors may consider having a combination of tax-deferred, tax-exempt, and taxable accounts to increase their personal tax diversification. Doing that provides multiple options both now and in retirement.

Tax-Efficient Investing Strategies: Investments

Not all investment types generate the same type of taxation. When deploying a tax-efficient investment strategy, it’s crucial to know how an investment is going to be taxed.

First, remember that there are two types of taxation on investment gains. The first is through capital gains tax on an investment sold at a profit. The second is on interest earned. The latter is typically taxed as income, which can have a higher rate than that of capital gains, which will be between 0% and 15% for most investors. This may be especially true for those in higher income tax brackets, who would pay their highest marginal rate on any interest income.

Next, it is helpful to know that some investment types are simply more tax efficient in their construction. For example, ETFs may be more tax efficient than mutual funds.

There’s an important lesson here: Investments that are less tax efficient might make sense to hold in a tax-sheltered account, like a retirement account, because no profit-related taxes are levied.

Investment types that are more tax efficient might be better suited for taxable accounts, where an investor must pay both capital gains tax and income tax on interest earned.

Here’s a list of some tax-efficient investment types:

Exchange-traded funds: Like a mutual fund but more tax efficient due to its construction and passive nature. Similarly, index mutual funds tend to be more tax efficient than actively managed funds. ETFs can be used to gain broad exposure to the stock, bond, and other investment markets.

Treasury bonds: Investors will not pay state income taxes on interest earned via Treasury bonds.

Municipal bonds: Bonds for local governments; 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: Dividends are generally taxed as income, whereas capital gains from the sale of stock tend to have a lower tax rate. Note that actively trading stocks can have additional tax implications (more on that in the following section).

Often, tax consequences will vary from person to person. A tax professional can help navigate tricky tax codes.

Tax-Efficient Investing Strategies: Trading

It may also be possible to minimize taxes via trading strategies.

For example, securities sold at an investment gain may be subject to capital gains tax (within a taxable account). But capital gains tax has two rates: short term, for investments held less than a year, when gains are taxed as ordinary income, and long term, for investments held longer than a year.

For investments held longer than a year, most investors will pay either 0% or 15%, depending on their income tax bracket. Those who earn more than $434,550 (filing single) are subject to a 20% rate.

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 canceling out an investment gain with an investment loss. It can be easier to understand by looking at an example:

Say 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 are due for the year.

So the investor could sell the investment at a loss, but thanks to the “wash sale” rule could not buy back the same investment within 30 days after losses are realized. The wash sale rule is in place to prevent people from abusing the ability to deduct capital gain losses. Also note that the wash sale applies to trades made by the investor, the investor’s spouse, or a company that the investor controls. But because this involves the forced selling 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.

Tax-loss harvesting rules also allow an investor to use some capital losses against their income taxes. In 2020, this can be done with up to $3,000 in realized investment losses.

A Platform With Plusses

Whether an investor would like to open a taxable, tax-deferred, or tax-exempt account, an online investing app like SoFi Invest® can help. There are zero fees to open an account and to buy investments.

Buying stocks, ETFs, and cryptocurrency is easy with SoFi Invest. And investors can stay up to date on breaking news, conduct research on investments, and place trades, all from within the SoFi app.

Best of all, SoFi offers access to financial planners at no additional charge. Question about saving, investing, or debt-payoff strategy? No problem. SoFi financial advisors are here to help.

For additional questions or specific advice regarding your personal tax situation, it’s best to consult a tax professional.

Ready to jumpstart your tax-efficient investing strategy? Open a traditional IRA, Roth IRA, or SEP IRA with SoFi Invest.


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