Investing is one of the most important things a person can do when it comes to building any amount of wealth, but it’s not simply about choosing the right assets. How you manage your investments from a tax perspective can make all the difference in your overall returns. Tax-efficient investing simply means trying to minimize the taxes you pay on your investment income; the more you keep, the better. Here’s a guide to some key tax-efficient investing strategies that will help you maximize your returns.
1. Utilize Tax-Advantaged Accounts
Probably the easiest way to invest tax-efficiently is to be fully invested in tax-advantaged accounts such as 401(k)s, IRAs, and Roth IRAs. Generally, in the course of the year, a contribution to a traditional 401(k) or to an IRA is tax-deductible. Furthermore, an investment made in either account will be deferred, so the tax on the gain will be due only when money is withdrawn, often during retirement. On the other hand, Roth IRAs are funded by the after-tax dollar, and qualified withdrawals taken during retirement are free from tax. If used effectively, these accounts can significantly reduce one’s tax burden over time.
2. Seek Long-Term Capital Gains
Investors also pay capital gains taxes at different rates, depending on how long they hold their investments. Short-term capital gains result from investments held for less than a year. These attract a flat rate set for ordinary income or 37% for top earners. Long-term capital gains result from the sale of investments held for more than a year. They are paid at different rates similarly to the income brackets, that is, at 0%, 15%, or 20%. You benefit from these lower tax rates if you hold investments for longer, thus saving a lot of money in terms of taxes.
3. Tax-Loss Harvesting
Tax-loss harvesting means you sell investments that have lost value, thereby reducing the taxes on your gains made on other investments. This would be very useful in a volatile market, as not all your assets may have yielded. Realized losses of approximately $3,000 in ordinary income can be offset in a given year, while additional losses realized can be carried over to later years. This strategy must, however, be used with caution to avoid the “wash-sale rule” that denies the tax deduction if one buys “substantially identical” securities within 30 days before or after a sale.
4. Consider Asset Location
An important approach for efficient tax investing is asset location: that is, placing the right type of investments in the right type of account from a tax standpoint. For example, investments that are more tax-efficient, such as index funds or municipal bonds, which yield little in taxes due, may be suitable for a taxable account. Conversely, you should put less tax-efficient investments, like bonds and actively managed funds that generate more taxable income, into a tax-advantaged account such as an IRA. You can be optimizing the overall tax impact on your portfolio by shifting and optimizing where you hold different types of assets.
5. Invest in Tax-Efficient Funds
Some mutual funds and exchange-traded funds are specifically structured for more tax efficiency than others. Index funds tend toward lower turnover rates compared to actively managed funds—this usually results in fewer generated taxable events. One foremost tax-efficient structure for investment is the exchange-traded fund (ETF), because, during the buying and selling of shares, the unique structure it possesses avoids capital gains taxes on behalf of the ETF itself. Indeed, investing in more tax-efficient funds can lower the taxes you owe for your gains on your investments.
6. Utilize Qualified Dividends and Municipal Bonds
Qualified dividends are taxed at the lower long-term capital gains rate rather than the higher ordinary income tax rates. So, investing in stocks or funds that pay qualified dividends may be a more tax-efficient way to generate income. Municipal bonds, issued by state and local governments, on the other hand, provide interest that is generally exempt from federal taxes and sometimes from state taxes too, making them an attractive option for investors in higher tax brackets.
Tax-efficient investing is the core of any successful investment strategy. You can reduce your tax bill and improve the after-tax return on your investments by taking advantage of tax-advantaged accounts, focusing on long-term capital gains, implementing tax-loss harvesting, attending to asset location, placing funds into tax-efficient investments, and putting qualified dividends and municipal bonds to work. In fact, the best practice is always to consult a financial advisor or tax professional who can apply these strategies in accordance with one’s particular situation and ensure that one is maximally tax-efficient in one’s investments.