The Basics of Tax-Efficient Investing

by Kevin Kroskey, CFP®, MBA

Investing wisely is about more than picking the right stocks or funds. It’s also about optimizing your returns by managing taxes. Taxes can take a significant bite out of your investment returns. By minimizing your tax liabilities, you can keep more of your hard-earned money, which, in turn, accelerates the growth of your investments over time.

Tax-efficient investing involves making wise choices about where and how you invest your money to minimize the impact of taxes. The primary objective is to legally reduce your tax liability, allowing you to retain more of your investment gains.

Whether you’re a seasoned investor or just starting your investment journey, understanding the basics of tax-efficient investing is essential. Here are some fundamentals of tax-efficient investing, which will give you a basic understanding of its importance.

Utilize Tax-Advantaged Accounts

Tax-advantaged accounts are your allies in tax-efficient investing. They offer tax benefits that can significantly boost your after-tax investment returns. Here are some common tax-advantaged accounts:

Plans such as 401(k), 403(b), 457(b) are sponsored by your employer and allow you to contribute pre-tax dollars, reducing your taxable income. Your investments grow tax-deferred until distributions are taken from the accounts. Many plans today also have a Roth option within the plan. Roth contributions are made with after-tax dollars and withdrawals in retirement are tax-free. This can be highly advantageous for investors expecting higher tax brackets during retirement.

Traditional IRAs & Roth IRAs are similar to 401(k)s. Traditional IRAs grow tax-deferred until withdrawal, and contributions are deductible subject to income limits if you participate in an employer plan. Contributions to Roth IRAs are made with after-tax dollars and withdrawals in retirement are tax-free. To be eligible to contribute to a Roth IRA, you must have earned income, and your modified adjusted gross income must be below a certain threshold, which changes annually.

Manage Taxable Accounts Smartly

“Asset location” refers to holding your investments in the proper accounts to minimize taxes. Typically, it’s a good practice to have tax-inefficient investments in tax-advantaged accounts and tax-efficient investments in taxable accounts.

Here’s a simple example: Tax-inefficient investments like taxable bonds, which generate taxable interest income, or actively managed mutual funds, which may generate high capital gains, are better suited for tax-advantaged accounts. Tax-efficient investments like index funds or ETFs with low taxable distributions can be held in taxable accounts.

Using tax-loss harvesting may also help. It involves selling investments that have declined in value to offset capital gains in your portfolio. This strategy can help you reduce your tax liability by using losses to offset gains or up to $3,000 of ordinary income yearly.

Embracing a long-term perspective helps tax-efficiency too. Investments held for more extended periods qualify for lower long-term capital gains tax rates. Frequent trading can trigger short-term capital gains taxed at a higher rate.

Basics on Investment Vehicles

Understanding investment differences can further enhance tax efficiency in your portfolio.

Index Funds and ETFs: Index and exchange-traded funds (ETFs) are known for their tax efficiency. Index funds typically have lower turnover (infrequent selling). ETFs have a unique structure that that is treated differently than mutual funds under tax law. Both can lead to lower taxable distributions when held in taxable accounts.

Municipal Bonds: Municipal bonds are issued by state and local governments. The interest income from municipal bonds is generally exempt from federal income tax and may also be exempt from state income tax if the bonds are issued within your state.

Real Estate Investment Trusts (REITs): REITs can provide diversification and income potential.  They are required by law to distribute at least 90% of their taxable income to shareholders in the form of dividends, which means investors can benefit from regular dividend payments, which can be taxed as ordinary income, capital gains, or a return of capital.

Final Thoughts

Tax-efficient investing is a fundamental strategy for maximizing investment returns and preserving wealth over the long term. By emphasizing the importance of tax efficiency, utilizing tax-advantaged accounts, implementing tax-efficient strategies, exploring tax-efficient investment vehicles, and staying informed about tax laws, you can work toward keeping more of your hard-earned. Doing so will likely help you achieve your financial goals and secure a prosperous future.

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Kevin Kroskey, CFP®, MBA

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Kevin Kroskey, CFP®, MBA is the Founder of True Wealth Design, a wealth management firm with deep expertise in retirement, tax, and investment planning, helping successful families and individuals Plan Smarter and Live BetterTM

Opinions and claims expressed above are those of the author and do not necessarily reflect those of ScripType Publishing.