TAX EFFICIENT INVESTMENT STRATEGIES

If you think understanding taxes and how to minimize them is difficult, you’re in great company. As Albert Einstein once said, “The hardest thing to understand in the world is the income tax.”

It’s certainly not easy! There are more than 4 million words in the tax code and regulations – that works out to roughly 17,000 pages.¹ Can you imagine going through all those pages to try and figure out the most tax-efficient ways to invest?

Fortunately, you can enlist the help of professionals to do that work so you don’t have to. But before we get into some tax efficient investment strategies, let’s start with a brief overview of the current tax structure.

UNDERSTANDING THE U.S. TAX SYSTEM

In the United States, we have a progressive tax system, which means the more money you earn, the higher your tax rate will generally be. While each state has its own individual tax rates and rules, federal income tax falls into three categories:

1. ORDINARY INCOME

This is income such as wages, bonuses and royalties. As the name implies, this type of income is taxed at what is known as ordinary income tax rates, which are based upon which tax bracket you are in. For 2024, the federal income tax rate tops out at 37% for individuals making $609,350 or more per year ($731,200 for married couples filing jointly).²

2. CAPITAL GAINS INCOME

This type of income usually comes from the sale of stocks, bonds, mutual funds, index funds, ETFs and other types of investments. The tax rate you pay on this type of income is determined by how long you hold the asset. Investments held for more than one year are taxed based on long-term capital gains rates, and for investments held for one year or less, short-term capital gains rates apply.

3. DIVIDEND INCOME

This is the money given to shareholders of certain stocks, usually on a quarterly or annual basis. The exact tax rate you pay on dividends will depend on whether it’s qualified or ordinary dividends. Qualified dividends have to meet certain criteria set by the IRS before achieving that classification, such as the kind of company paying the dividend and how long the shares have been held.

Why all the different rates? And why do some types of income seem to be favored over others, like long-term over short-term, or capital gains over ordinary income?

One reason is that long-term investments can stimulate economic growth, so the government would encourage that type of behavior from investors. And this difference in tax rates is one of the reasons that financial planners like to focus on the tax consequence of each investing strategy. Because there are different rates for different investment incomes, there’s plenty of flexibility in how you can be tax-efficient in your investment strategies.

To help start you on the right path, here are six strategies you can consider to help minimize your tax liability:

1. CONTRIBUTE TO THE MOST TAX-ADVANTAGED ACCOUNTS

First, it’s important to understand the difference between a taxable account and a tax-advantaged account and how to use each. A taxable account, like your brokerage or bank account, are subject to normal federal tax rules. On the other hand, tax-advantaged or tax-deferred accounts can either exempt you altogether or allow you to pay taxes later.

These include a wide range of investment accounts that offer some sort of tax benefit. This could be a tax-deferred retirement account, such as a traditional 401(k), 403(b), 457, or deductible IRAs where pretax contributions are made and able to grow tax-free until you withdraw them.

Other tax-advantaged accounts include Roth IRAs, 529 college savings accounts and health savings accounts in which you can contribute post-tax funds that are then allowed to grow tax-free. All of these can contribute to tax-efficient investment strategies. HSAs, in particular, can be considered triple tax-advantaged – contributions aren’t taxed on the way in, during accumulation or when you finally withdraw the funds as intended.

2. UNDERSTAND YOUR DIFFERENT INVESTMENTS AND ASSETS

Knowing the kinds of assets you own and the types of accounts they are held in is an important part of tax-efficient investing.

There are a lot of different variables involved in calculating a fund’s tax efficiency, but in general, investment funds can be ranked in order from least efficient to most efficient. For example, passive ETFs are generally more tax efficient than other types of funds. Also, certain asset classes tend to reduce your tax burden more than others.

Understanding the respective benefits and drawbacks of the different asset classes you’re invested in is an important factor in deciding which types of accounts to hold them in. This is where the help of a financial planner can be invaluable.

3. MANAGE CAPITAL GAINS INCOME WITH TAX-LOSS HARVESTING

Tax-loss harvesting is a strategy that can be used to defer capital gains taxes, as it lets you realize losses today to offset some of the capital gains tax you may owe in the current tax year or in future years.

For example, a hypothetical investor might have an investment that was bought 10 months ago and, therefore, is subject to short-term capital gains tax rates, which would be their ordinary income tax rate bracket. Selling the investment recognizes a capital gain of $32,000, which would mean $11,200 in taxes due – 35% of the gain.

However, if they hold another investment, which is also held for less than a year, and sell for a capital loss of $35,000, the loss offsets the gain. Not only do they save $11,200 in taxes, they also have an extra $3,000 that can be used to offset other ordinary income.

It’s important to consider that tax-loss harvesting doesn’t allow you to avoid paying investment tax, just to defer it, putting it off into the future so that your money can keep working for you in the present. It is also equally important to note that tax-loss harvesting is only allowed for a taxable brokerage account and the like. 

4. USE SMART RETIREMENT WITHDRAWAL STRATEGIES

Strategic withdrawals are just as important to consider as the investments in your strategy. It’s important to determine when to take money out of different types of accounts and to make sure you do it in a tax-efficient order. This can be difficult to ascertain if you hold different types of taxable and nontaxable accounts.

The challenge is making sure you optimize when to withdraw money to reduce tax implications. But what order is the right order? There’s not one rule that works for everyone, but as a starting point, you should consider making withdrawals from a taxable account first, like brokerage accounts, bank savings accounts and other monies in non-tax-advantaged accounts. This is because you have to pay taxes on any interest, dividends and realized capital gains. These accounts offer the least ability to defer taxes, so one idea would be to draw them down first.

Then you would tap into tax-deferred accounts next, like a 401k or traditional IRA, and after that, tax-exempt accounts like Roth IRAs or HSAs. But there are times when this type of account ordering isn’t the wisest path, and once again, this is where a financial advisor can help.

5. GIVE TO CHARITY

Charitable giving isn’t just an altruistic act, it’s something that can help mitigate the impact of taxes as part of a comprehensive wealth management strategy.

For cash donations, you can take an annual income tax deduction of up to 60% of your adjusted gross income or AGI. For noncash items, like stock or real estate, the limit is typically 30% of your AGI. If you do donate noncash assets to charity, consider donating those with the highest appreciation because not only will you be benefiting a charitable cause, but you will also be maximizing the asset’s value as a tax deduction.

To make your charitable giving as tax efficient as possible, you need to time it right, which can be done by using more complex giving strategies involving a donor-advised fund.

6. STAY TAX AWARE ALL YEAR ROUND

It may sound simple, but one of the best things you can do is to plan for and manage the tax efficiency of your investments all year long.

That involves reviewing your investments and financial plan on a regular basis during the year. Obviously, this can be an overwhelming task, which is why it might make sense to talk to a financial planner who can help you plan your investment strategy for tax efficiency.