Tax Efficient Investing

Taxes are important! They fund our education system, roads, and investments in the future of our country. But when you are investing, you need to keep costs in mind and every investment has costs - opportunity costs, fees, and potential losses to name a few. Among these costs, taxes are ones where you can exercise a modicum of control through tax-efficient investing, which can help manage your tax burden and maximize your bottom line (1).

By understanding the tax implications of different types of accounts, as well as the investments you choose (stocks, bonds, funds, etc.), you can determine the most tax-efficient strategy for your portfolio.

What is Tax Efficient Investing?

Tax efficient investing allows you to manage taxes generated by investment activities. Investors can use a variety of methods to manage taxes efficiently, including selecting tax-advantaged investments and using IRAs, 401(k)s and other tax-deferred accounts.

Tax efficient investing combines selection of accounts and investments with tax-efficient strategies.

There are several investment account types that can help to reduce your tax basis (2). These include: Individual Retirement Accounts (IRAs and Roth IRAs); other retirement accounts like 401(k) and 403(b); 529 college funding plans (3); and Health Savings Accounts (HSAs).

Tax-aware investors can also choose from specific investments that provide tax benefits. These include:

Treasury securities. Investors do not pay state or local taxes on interest earned from Treasuries.
Municipal bonds. Income from municipal bonds is usually free from federal income tax, and often state and local taxes as well.
Tax-managed funds. Some mutual funds are managed with the specific objective of reducing tax impacts by, among other methods, purchasing municipal bonds and reducing turnover.
Passively managed funds. Exchange-traded funds (ETFs) and index mutual funds that passively track an index are naturally tax-efficient because managers do not buy and sell securities as often as actively managed funds (4,5). This reduces the tax obligations created by short-term capital gains on investments held less than a year.

Finally, there are tax efficient actions. Here are some of the most common and effective ones:

Capital gains strategies. One of the most widely used tax strategies is delaying the sale of investments in order to take advantage of long-term capital gains treatment. Gains on investments held less than a year are taxed as ordinary income, while gains on assets held more than a year are taxed as long-term capital gain rates of 15% for most investors.
Tax Loss harvesting. By selling money-losing investments you can shelter gains on profitable investments from taxes. When losses on investments in a given year total more than investment gains for that year, the losses can shelter up to $3,000 of earned income. Plus, losses can be carried forward to later years.

Why Is Tax Efficient Investing Important?

The Schwab Center for Financial Research evaluated the long-term impact of taxes and other expenses on investment returns. And while investment selection and asset allocation are the most important factors that affect returns, the study found that managing the amount of taxes you pay also has a significant effect (6,7). Part of the reason is that the money you pay in taxes is lost forever. You lose the growth that money could have generated if it were still invested. When it comes to investing, it’s not just how much you make that matters—it’s how much you keep after taxes.

How to Invest with Tax Efficiency

There are numerous ways to do tax efficient investing, such as allocating higher-yield assets like high-dividend-paying stocks, to tax-deferred and tax-exempt accounts, such as IRAs, to minimize your exposure to current taxes.

Or, if your tax burden is rising, you can max out contributions to your account under your employer’s 401(k) plan, since contributions can be made on a pretax basis. Contributing to a traditional IRA can also lower your taxable income for the current year, since contributions may be tax-deductible.

And since qualified distributions from a Roth IRA are tax free, assets you believe will have the greatest potential for higher return are best placed inside a Roth IRA, when possible.

Managing your investments with tax efficiency in mind can help you hold on to more of your pre-tax and after-tax dollars. Tax efficient investing techniques are accessible to almost everyone—it just takes some planning to reap the benefits.

To help find the right tax efficient investment for you, try the following searches:

References:

Magnifi does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.

Pursuant to requirements imposed by the Internal Revenue Service, any tax advice contained in this communication (including any attachments) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any tax-related matter. Please contact us if you wish to have formal written advice on this matter.

A 529 plan is a college savings plan that allows individuals to save for college on a tax-advantaged basis. Every state offers at least one 529 plan. Before buying a 529 plan, you should inquire about the particular plan and its fees and expenses. You should also consider that certain states offer tax benefits and fee savings to in-state residents. Whether a state tax deduction and/or application fee savings are available depends on your state of residence. For tax advice, consult your tax professional. Non-qualifying distribution earnings are taxable and subject to a 10% tax penalty.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices does not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends. The Standard & Poor's 500 (S&P 500) Index is a free-float weighted index that tracks the 500 most widely held stocks on the NYSE or NASDAQ and is representative of the stock market in general. It is a market value weighted index with each stock's weight in the index proportionate to its market value.

Exchange Traded Funds (ETF’s) and mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

Active portfolio management, including market timing, can subject longer term investors to potentially higher fees and can have a negative effect on the long-term performance due to the transaction costs of the short-term trading. In addition, there may be potential tax consequences from these strategies. Active portfolio management and market timing may be unsuitable for some investors depending on their specific investment objectives and financial position. Active portfolio management does not guarantee a profit or protect against a loss in a declining market.

Adams, Hayden, “Tax-Efficient Investing: Why Is It Important?” Charles Schwab, 12 May 2022, https://www.schwab.com/resource-center/insights/content/importance-tax-efficient-investing.

Asset Allocation does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.

Disclosures:

Mutual Funds and Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.