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Tax efficient investment strategies

Ways to help you keep more of your hard-earned money.

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Last updated: September 26, 2022 |

Article published: March 1, 2022

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 around 4 million words in the tax code and regulations – that works out to roughly 9,000 pages. 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.

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 be. And according to an analysis from taxfoundation.org, Americans as a whole spend more money on taxes than on food, clothing and housing combined.

Each state has its own individual income tax rates and rules. On the federal level, every type of income is taxed, and they fall into three categories:

1. Ordinary income

This is income such as wages, bonuses and royalties, and as the name implies, this type of income is taxed at what is known as ordinary rates, which are based upon which tax bracket you are in.

2. Capital gains income

This type of income comes from the sale of stocks, bonds, mutual 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 investment. Income from investments held for more than one year is taxed based on long-term capital gains rates, and for investments held less than a year, 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 unqualified. Dividends have to meet certain criteria set by the IRS to be classified as qualified, such as the kind of company paying the dividend and how long the shares have been held.

Why all the different rates? 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 stimulate economic growth, so the government wants to encourage that type of behavior.

And this friction, this difference in tax rates, is one of the reasons that financial planners like to focus on the tax consequences of an 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.

Contribute to the most tax-advantaged accounts

These are any type 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 contribute post-tax funds that are then allowed to grow tax-free. All of these can contribute to tax-efficient investment strategies.

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 be more tax efficient 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.

Manage capital gains income

Tax-loss harvesting is a strategy that can be used to maximize the tax benefits of capital gains, as it lets you realize losses today to offset capital gains taxes that may be due 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.

But if they hold another investment, also held for less than a year, which they 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 note that tax-loss harvesting doesn’t allow you to avoid taxes, just to defer them, putting them off into the future so that your money can keep working for you in the present.

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 taxes. 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 taxable accounts 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 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.

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, 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.

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.

 

Material discussed is meant for general illustration and/or informational purposes only, and it is not to be construed as tax or legal advice. Although the information has been gathered from sources believed to be reliable we do not guarantee its accuracy or completeness.

Neither Edelman Financial Engines, a division of Financial Engines Advisors L.L.C., nor its affiliates offer tax or legal advice. Interested parties are strongly encouraged to seek advice from qualified tax and/or legal experts regarding the best options for your particular circumstances.

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