Tax-Aware Investing: Lowering Your Investment Taxes

Tax-aware investing is the practice of making investment decisions to maximize after-tax returns. This approach focuses on keeping more of what you earn by minimizing the impact of taxation, rather than just earning the highest possible pre-tax return. It involves strategic choices to minimize “tax drag,” which is the reduction of a portfolio’s growth due to taxes.

By understanding how different investment returns and account types are taxed, investors can structure their portfolios more efficiently. Tax-aware investing integrates tax considerations into an overall investment strategy, alongside factors like asset allocation and risk tolerance. These decisions can significantly enhance long-term wealth.

Fundamental Tax Concepts for Investors

Understanding how investment returns are taxed is the foundation of this strategy. Different types of investment income are taxed in distinct ways, creating opportunities for strategic planning.

Profits from selling an investment are known as capital gains, and their tax treatment depends on how long the asset was held. A short-term capital gain results from selling an asset held for one year or less, and this profit is taxed at the investor’s ordinary income tax rates, which range from 10% to 37%. A long-term capital gain, from an asset held for more than one year, is taxed at preferential rates of 0%, 15%, or 20%, depending on the investor’s total taxable income. For 2024, a single filer with taxable income up to $47,025 could pay 0% on long-term gains.

Dividends, which are distributions of a company’s earnings to shareholders, are also taxed in two different ways. Qualified dividends are taxed at the same favorable long-term capital gains rates. To be considered qualified, the dividends must be from an eligible corporation and the investor must meet a minimum holding period for the stock. Any dividends that do not meet these criteria are considered non-qualified and are taxed at the investor’s higher ordinary income tax rate.

Finally, interest income from sources like corporate bonds, certificates of deposit (CDs), and savings accounts is the most tax-inefficient. This income is taxed at ordinary income rates, similar to wages.

Strategic Asset Location

Asset location is the strategy of deciding where to hold different investments to minimize taxes. The principle is to place investments in accounts that best shelter them from taxes.

Investors have access to three main types of accounts with unique tax profiles. Taxable accounts, like standard brokerage accounts, have no upfront tax benefits, and income is taxed annually. Tax-deferred accounts, such as traditional 401(k)s and IRAs, allow investments to grow tax-free until retirement, when withdrawals are taxed as ordinary income. Tax-free accounts, like Roth IRAs and Health Savings Accounts (HSAs), are funded with after-tax dollars, and qualified withdrawals are never taxed.

The framework for asset location is to place the most tax-inefficient assets in accounts with the most tax protection. Investments that generate significant and frequent taxable income, such as corporate bonds, high-yield bonds, and real estate investment trusts (REITs), are prime candidates for tax-deferred accounts like a traditional IRA or 401(k).

Conversely, tax-efficient assets should be placed in taxable brokerage accounts. This includes investments like individual stocks held for the long term, which generate long-term capital gains that are taxed at lower rates only when sold. Index funds and exchange-traded funds (ETFs) with low turnover are also well-suited for taxable accounts because they generate fewer taxable capital gains distributions.

Selecting Tax-Efficient Investments

The choice of investments is also a part of a tax-aware strategy. Some investment vehicles are more tax-efficient than others due to their structure, which can lower the tax bill in a taxable account.

Exchange-traded funds (ETFs) are a primary example, often being more tax-efficient than actively managed mutual funds. This efficiency comes from their structure, which helps avoid realizing capital gains, and their lower portfolio turnover, which results in fewer taxable distributions to investors. In 2023, only 2.5% of ETFs distributed capital gains, compared to 31.5% of mutual funds.

Municipal bonds represent another category of tax-efficient investments. Interest income from these bonds, issued by state and local governments, is exempt from federal income tax and may also be exempt from state and local taxes for in-state residents, creating a source of tax-free income. This makes them particularly attractive for high-income earners in higher federal tax brackets and who live in states with high income taxes.

A metric for evaluating a fund’s tax efficiency is its turnover ratio, which represents the percentage of a fund’s holdings that have been replaced in a given year. A high turnover ratio means the fund manager buys and sells frequently, which can create short-term capital gains that are passed on to shareholders and taxed at higher rates. A lower turnover ratio suggests a more tax-efficient fund that minimizes taxable events.

Active Portfolio Tax Management Techniques

Investors can also use active management techniques in taxable accounts to enhance after-tax returns. These strategies involve timing transactions to optimize tax outcomes and reduce the tax impact of portfolio changes.

The most widely used technique is tax-loss harvesting. This strategy involves selling an investment that has decreased in value to realize a capital loss, which can then be used to offset capital gains from other investments. If losses exceed gains in a given year, up to $3,000 of the excess loss can be used to offset ordinary income, with any remaining losses carried forward to future tax years.

A component of tax-loss harvesting is the wash-sale rule. The IRS prohibits an investor from claiming a loss on a security if they purchase a “substantially identical” security within 30 days before or after the sale. While the IRS has not provided a rigid definition of “substantially identical,” selling an S&P 500 index fund and purchasing a total stock market index fund is considered acceptable.

The inverse strategy, tax-gain harvesting, can be beneficial for investors in a low-income year. This involves intentionally selling appreciated assets held for over a year to realize long-term capital gains while in a low tax bracket, such as the 0% rate. For 2024, a married couple filing jointly with taxable income up to $94,050 falls into this bracket. Realizing gains at a 0% rate increases the investment’s cost basis, reducing the taxable gain on a future sale.

Another technique involves donating appreciated securities to a qualified charity. Donating stock held for more than one year can provide a dual tax benefit. First, the donor can deduct the full fair market value of the stock. Second, they avoid paying capital gains tax on the appreciation.

Tax-Conscious Withdrawal Planning

Tax-aware principles also apply in retirement, where withdrawal sequencing from different accounts can affect an investor’s lifetime tax bill. A strategic approach to withdrawals can preserve wealth and help manage annual income to stay in lower tax brackets.

Conventional wisdom advises retirees to draw from their accounts in a specific order to maximize the benefits of tax-advantaged accounts. The process begins with taxable accounts, like a standard brokerage account. Withdrawing from these accounts first is advantageous because only the capital gains are taxed, often at lower long-term rates.

Once taxable accounts are depleted, the next source of funds should be tax-deferred accounts, like traditional 401(k)s and IRAs. Every dollar withdrawn from these accounts is treated as ordinary income and is fully taxable.

The final accounts to be tapped are tax-free accounts, such as Roth IRAs and Roth 401(k)s. These are saved for last because all qualified withdrawals are completely free from federal income tax. Preserving these funds provides a source of tax-free income that offers flexibility to manage taxable income throughout retirement.