When you start your investing journey, you may immediately be impressed by the potential returns. Unfortunately, many people underestimate the impact of taxation on your returns. If you don’t consider it beforehand, the IRS can take a massive chunk of anything you make. Fortunately, there are tax advantaged accounts and strategies that can help you to minimize the tax burden and maximize your returns.
The Tax Efficient Investing Basics
Tax efficient investing may seem complicated but basically it involves choosing the right accounts and strategies to minimize the amount of tax on your returns. With the right mix of accounts, you can reduce the tax paid on your investments to leave you with more of your funds to grow.
In simple terms, the more you are able to minimize your tax burden, the more money you’ll have to invest, which will allow you to compound your growth over the medium to long term. Essentially, you will aim to maximize your returns by limiting losses to tax. You can review the associated tax obligations for different accounts before you invest to ensure that you pay as little as possible.
The Types of Investment Accounts
To leverage the potential of tax efficient investing, you need to appreciate the differences between the different types of investment accounts.
| Type of Account | Key Features | Tax Advantages | Eligibility |
|---|---|---|---|
| Traditional IRA | Individual retirement account. Contributions are typically tax-deductible. | Tax-deferred growth. Pay taxes when withdrawing in retirement. | Income limits apply for tax-deductible contributions if covered by an employer plan. |
| Roth IRA | Individual retirement account. Contributions are made with after-tax dollars. | Tax-free growth and withdrawals in retirement. | Income limits apply for eligibility to contribute. |
| 401(k) | Employer-sponsored retirement plan. Contributions are pre-tax, sometimes with employer matching. | Tax-deferred growth. Pay taxes when withdrawing in retirement. | Offered through employers. Annual contribution limits apply. |
| Roth 401(k) | Employer-sponsored retirement plan. Contributions are made with after-tax dollars. | Tax-free growth and withdrawals in retirement. | Offered through employers. Annual contribution limits apply. |
| Health Savings Account (HSA) | Tax-advantaged account for medical expenses. Must be paired with a high-deductible health plan (HDHP). | Contributions are pre-tax, growth is tax-free, and withdrawals for medical expenses are tax-free. | Must have an HDHP. Contribution limits apply. |
| 529 Plan | Education savings plan. Can be used for K-12 tuition and higher education expenses. | Tax-free growth and withdrawals for qualified education expenses. | No income limits. Contribution limits vary by state. |
| SEP IRA | Simplified Employee Pension IRA for self-employed individuals or small business owners. | Tax-deferred growth. Contributions are tax-deductible. | Must be self-employed or a small business owner. Contribution limits apply. |
| SIMPLE IRA | Savings Incentive Match Plan for Employees for small businesses. | Tax-deferred growth. Contributions are tax-deductible. | Employers with fewer than 100 employees. Employee salary reduction contributions allowed. |
| 403(b) | Retirement plan for employees of public schools and tax-exempt organizations. | Tax-deferred growth. Pay taxes when withdrawing in retirement. | Offered through eligible employers. Annual contribution limits apply. |
| 457(b) | Retirement plan for state and local government employees. | Tax-deferred growth. Pay taxes when withdrawing in retirement. | Offered through eligible employers. No early withdrawal penalty before age 59½ if separating from service. |
| Coverdell ESA | Education Savings Account. Can be used for K-12 and higher education expenses. | Tax-free growth and withdrawals for qualified education expenses. | Income and contribution limits apply. |
| Traditional Brokerage Account (with Tax-Loss Harvesting) | Standard investment account. Gains and losses can be offset during tax filing (not fully tax-advantaged). | Gains taxed at lower capital gains rates, and losses can reduce taxable income. | No income limits. No contribution limits. |
Taxable Accounts
When you start investing, you’re likely to be offered a brokerage account or individual investment account. These are taxable accounts, which means that you’ll be subject to tax on the increase in value when you sell an investment. This capital gains tax is calculated according to how long you’ve held your investment.
Short term capital gains tax applies to investments that were held for one year or less and you’ll pay a rate equivalent to your ordinary income tax. On the other hand, if you’ve held the investment for longer than one year, you’ll pay long term capital gains tax. This is taxed at a preferential rate of between 0% to 20% depending on your existing tax bracket.
However, the advantage of using a taxable account is that they offer flexibility. You’re not likely to find any contribution restrictions or withdrawal limits compared to if you were using a tax advantaged account.
Tax Advantaged Accounts
There are two main forms of tax advantaged account; tax exempt and tax deferred.
Tax Exempt
The contributions to tax exempt accounts, such as Roth IRAs, are made using after tax dollars. This means that while you won’t get an upfront tax break, your investment can grow tax free. So, you won’t owe any tax on withdrawals you make during retirement. However, if you’re below retirement age and want to make a withdrawal, you will face restrictions and penalties.
Tax Deferred
Tax deferred accounts allow you to contribute with funds before the taxes are taken out. You can use your pre-tax dollars and your investment will grow as a tax deferred fund. This means that you won’t owe any taxes on the investment growth until you start withdrawing the funds in retirement.
Good examples of this type of account are traditional IRAs and 401ks. These are retirement accounts that can be beneficial if you anticipate being in a lower tax bracket after retirement. Essentially, you can invest throughout your career and then pay the tax owed later, when your income tax rate is lower. Another benefit of tax deferred accounts is that since the contributions are made using pre-taxed dollars, you will lower your taxable income. This means that you could end up paying less taxes for the whole year.
Asset Allocation
Many investors use both taxable and tax advantaged accounts to create the most efficient strategy and maximize returns. However, before you can decide which accounts work best for you, you will need to understand asset allocation. Essentially, this is how you divide your portfolio between different investment vehicles such as fixed income assets and equities. This will allow you to balance the rewards and risk according to your unique financial goals and risk tolerance preferences.
Tax Efficient Investment Strategies
You can benefit from tax advantaged investment accounts, but you do need a good strategy to take full advantage of the potential. These accounts do lack flexibility and have annual contribution limits and you don’t want to get stung if you trigger penalties or taxes with non qualified withdrawals or other activity.
This means that if you want to maximize your tax efficiency, you need to put your investments into the right account. Generally, if you have investments that lose less earnings to tax, they are better suited to a taxable account. On the other hand, investments that are more vulnerable to taxation are a good choice for your tax advantaged account.
Remember that your after tax returns are more important than your pre tax returns. It’s great making impressive returns on paper, but you’ll spend your after tax dollars, so you want to be able to keep more of your money.
Where to Keep Your Money
If you want to maximize your returns, you need to adopt an active tax management approach, considering where to put your investments before you buy or sell.
If you’re buying stocks or bonds, it is usually a good idea to put some into your tax advantaged account, such as your 401k. This will allow you to deduct the amount you invest from your taxable income and you won’t pay taxes on your gains until you make a retirement withdrawal. When you do retire and want to access the money, it will be taxed at your at-retirement income bracket, which is likely to be lower than your current bracket. Additionally, many employers will match your 401k contributions, which will significantly increase your investment fund.
Just bear in mind that if you have a need to withdraw or cash out your investments before you reach retirement age, you are likely to face a penalty. Also, tax advantaged accounts do have contribution limits, so you can’t rely on one as your sole investment account.
You will need to develop a strategy to divide up your investment between your taxable and tax advantaged accounts that will maximize the returns. Your strategy will also need to include when you plan to sell.
If you adopt a passive “buy and hold” investment strategy, you can typically expect lower taxes, as each time you sell any asset, you risk capital gains tax. This means knowing when to sell is crucial.
Remember that long term capital gains have a lower taxation rate compared to short term capital gains. If you’re at the top of your income bracket, you could end up paying far more tax if you sell any asset that you’ve held for less than one year.
For example, the long term capital gains tax rate is 20% if you’re a top earner. However, the top income bracket is 37%. Even after you factor in a 3.8% net investment tax, it works out at a maximum capital gains tax of 23.8%, vs the 37% income tax. So, if your investment is almost a year old, chances are it is best to hold on a little longer before you sell.
Tax Loss Harvesting
Sometimes, you can use your losses as an advantage with tax loss harvesting. This involves intentionally selling unprofitable assets at a loss, which will help you to reduce the capital gains tax incurred with your other investments. Basically, you’re deducting the losses from your gains to reduce your overall tax bill.
In the US, you can take tax loss harvesting one step further, as if your total capital losses exceed the total capital gains, the IRS allows you to write off up to $3,000 from your income. If the losses are more, you can even carry them over to future tax returns until you have harvested all your losses.
Of course, you shouldn’t intentionally seek out losing assets just for a tax break. If an asset still has good long term prospects, it may not be worth taking the tax break. You should also purchase similar assets when you sell them for tax harvesting for a well rounded strategy.
You also need to ensure that your sales will not violate the “wash sale” rules. In simple terms, your write off will not be permitted if you reinvest the funds into the same stock or asset, or something substantially similar within 30 days.
Choosing Tax Efficient Investments
Regardless of the account, you need to know that some investments will be taxed less than others. Passive funds such as ETFs and index funds are typically more tax efficient as they have fewer transactions and therefore fewer taxable events. Conversely, actively managed mutual funds have multiple transactions and greater opportunity for taxation.
Likewise, not all bonds are identical. You need to check how bonds are taxed and incorporate this into your strategy and returns. For example, US municipal bonds are federal tax exempt and may not be subject to state or local taxes. Treasury bonds are similar, but corporate bonds do not have these benefits.
Again, it varies according to where the investment is held. As an example, you need to hold a tax exempt bond directly to not pay tax on the income. If it is held in a retirement account, it will be treated as ordinary income.
Strategies to Lower Your Investment Taxes and Maximize Returns
While you will need to consider your personal circumstances and preferences, there are some great strategies that will help you to lower your investment taxes and maximize returns.
Think About Tax Efficient Investments
There are various factors to consider when you’re picking investments to add to your portfolio, but whether it is a tax efficient investment should be included in the decision. If you’re purchasing for your non retirement account, you need to weigh cost and tax efficiency. So, it is a good idea to choose investments that have built in tax efficiency, such as index funds and certain ETFs and mutual funds.
In fact, ETFs could potentially offer additional tax advantages. The way the transactions are settled may allow avoiding triggering some of the capital gains.
Consider an HSA
If you’ve reached your retirement account limits and want to reduce your taxable income, you should put some of your income into a Health Savings Account or HSA. This is a flexible account that allows you to set aside pre-tax funds to pay for any qualified medical expenses. The money you deposit in the current year that isn’t used can remain in the account for any future medical withdrawals tax free. After you reach retirement age, you can access the funds penalty free for any reason, but they will be subject to tax.
You’ll be eligible to open a HSA if you’re enrolled in a high deductible health plan. If you’re unsure, an advisor can help you determine if it is sensible to open one.
Use Asset Allocation
Choosing tax efficient investments can help you to maximize your after tax returns, but you also need to choose the right account to hold your investments. You need to divide your assets among your taxable and tax advantaged accounts, putting investments with a heavier tax burden into the tax advantaged account and tax efficient ones into your taxable accounts.
For example, you should hold stocks, individual tax exempt bonds and index ETFs in your taxable account, while actively managed mutual funds, and taxable bonds into your non taxable account.
Watch out for Offset Gain Opportunities
Investors are taxed on their net capital gains, which is the amount you gain minus the investment losses. So, any realized losses will help to lower your tax burden. Tax loss harvesting can help you to reduce the amount of tax you’ll pay and you can use up to $3,000 of net losses each year to offset federal income tax. You can also carry forward your losses into future tax years. Just watch out for the wash sale rule we discussed earlier.
Be Strategic About Your Withdrawals
When you start withdrawing from your portfolio, you need to be strategic and think about taxation. If you draw down from a non retirement account, you need to think about taking all the income and moving it to a money market account rather than reinvesting. This will prevent you from paying tax twice.
If you reinvest the income produced by dividends, capital gains and interest, and then that asset produces a gain, you will owe tax on the income produced and the capital gains on the appreciation.
Also, if you expect your future tax rate to be higher, you may want to draw down from your tax deferred account if you need access to funds.
Maximize Your Charitable Giving
If part of your investing goals is philanthropic activity, you can make the most of it. There are gift appreciated securities such as ETFs and mutual funds that can help you to minimize future capital gains. Just be aware that not all charities accept investment donations.
If you don’t take a standard tax deduction, you can itemize cash donations on your return, bunching charitable donations, so you can itemize for a larger tax deduction. If you donate directly to a qualified charity using a qualified distribution, you can make a gift from your IRA. You’ll need to meet certain requirements such as meeting the age requirement.
If you plan on making large donations over time, it could be beneficial to establish a donor advised fund or DAF. This allows you immediate tax deductions for your contributions, even if you don’t immediately distribute the funds to charities. You don’t necessarily need to speak to an investment professional to set up a DAF, as you can complete the process yourself in just a few basic steps.
Investing can be a little daunting, particularly if you’re a complete newbie. But you can get off to the right start with your choice of account. If you want to maximize your returns and minimize the amount you have to pay over to the IRS, you need to think about the accounts you use and the strategies you implement. While you may be keen to just start buying and selling, it is far better in the medium to long term, to spend a little time considering the options and deciding which accounts will work best for you.
It is usually a good idea to have both a taxable and tax advantaged account, but the specific accounts will depend on your circumstances, investment goals and preferences. So, think about your goals and examine which accounts will be best suited to help you. If in doubt, you can discuss your requirements and queries with an investment professional. It is well worth planning your accounts and strategies in advance or you could face the unpleasant surprise of a hefty tax bill come tax season. So, don’t let the IRS swallow up a massive chunk of your investment returns and use the right investment accounts to your advantage.
