Do You Know These Top Tax-Efficient Investing Strategies?

The point of investment accounts is to generate a return. But with every investment comes a cost—and one of the biggest costs can be taxes, especially if you’re in a higher tax bracket.

The solution? Tax-efficient investing. Here’s everything you need to know to understand what that means, and what strategies you should consider and discuss with your financial advisor.

What is a tax-efficient investment, and why does it matter?

Tax-efficient investing means managing your investments in such a way that your tax burden is minimized.

The Schwab Center for Financial Research recently found that minimizing taxes is one of the most important considerations when it comes to investment returns, hot on the heels of investment selection and asset allocation.

Strategy #1: Opt for investments that are lower-tax or tax free

Here are a few to consider:

Tax-managed and exchange-traded funds (ETFs)—These generate fewer capital gains distributions, which means lower taxes.

Municipal bonds—The interest income isn’t subject to federal tax, and could be exempt from state and local taxes.

Treasury bonds—Also exempt from state and local taxes.


Strategy #2: Diversify based on tax treatment

You’re familiar with the concept of diversification, but did you know that you should also consider diversifying based on tax treatment?
There are essentially two types of investment accounts: taxable and tax-advantaged. Taxable accounts typically hold stocks or mutual funds. Tax-advantaged accounts include your 401(k), IRA or Roth IRA.

Generally speaking, you’ll reap the most value over the long term by holding tax-efficient investments (those mentioned above in Strategy #1) in taxable accounts and less tax-efficient investments in tax-advantaged accounts. Investments that aren’t as tax efficient include funds that generate significant short-term capital gains, high-yield bonds, and real estate investment trusts.

If you’re unsure which tax bracket you’ll be in once you hit retirement, tax diversification offers you flexibility to manage that. In other words, you’ll be able to select which accounts to withdraw money from in retirement based on the tax implications.

This also matters if you are doing any legacy planning, since different accounts are subject to different gift or estate taxes.

Strategy #3: Implement tax-loss harvesting

If you sell investments that are down, and replace them with similar investments, you can use what is called tax-loss harvesting to reduce taxes and therefore keep more of your money invested.

If your investment losses of one type exceed your gains of a similar type in a particular tax year, you can use them to offset up to $3,000 (for joint filers) of earned income each year. If you have losses in excess of $3,000, you can carry those forward to future tax years indefinitely.

It’s best to incorporate tax-loss harvesting into your year-round tax planning and investing strategy.

Strategy #4: Go for long-term capital gains

If you hold a stock or other asset for less than a year, any gains you realize will be taxed at your regular income tax rate. You’re much better off holding stocks longer than a year so your gains will instead be taxed at the long-term capital gains rate (currently 0%, 15% or 20%, depending on your taxable income and filing status).

Strategy #5: Periodically rebalance your portfolio with taxes in mind

Rebalancing your portfolio means putting your target asset allocation back in alignment with your overall financial goals, as well as with your risk tolerance. This is an important part of your overall strategy, but rebalancing can have tax ramifications because it involves buying and selling assets.

You can mitigate this in two ways: First, by focusing your rebalancing on your tax-advantaged accounts where possible. Second, by adding money to asset classes that are underperforming.

Key takeaway:

Don’t just think about taxes at tax time. Work with your financial advisor to gain whatever control you can over your portfolio’s tax situation, and make sure to do so in ways that are consistent with your overall investment goals and financial strategy.

To discuss which of these strategies may be appropriate for your situation, contact a financial advisor with Ironwood Wealth Management today.