How To Invest Tax-Efficiently, In Four Easy Steps

How To Invest Tax-Efficiently, In Four Easy Steps
Theodora Lee Joseph, CFA

about 1 year ago5 mins

  • Tax-deferred accounts are great if you expect to be in a lower tax bracket during retirement, while taxable accounts provide you with more flexibility when withdrawing your money.

  • Tax-inefficient investment types belong in tax-advantaged accounts, while tax-efficient investments are best in taxable accounts.

  • Typically, the fewer trades you make, the less you’ll pay in taxes.

  • Timing when you sell your losing investments and when you realize your gains can help you reduce your taxable capital gains, but only in a taxable account.

Tax-deferred accounts are great if you expect to be in a lower tax bracket during retirement, while taxable accounts provide you with more flexibility when withdrawing your money.

Tax-inefficient investment types belong in tax-advantaged accounts, while tax-efficient investments are best in taxable accounts.

Typically, the fewer trades you make, the less you’ll pay in taxes.

Timing when you sell your losing investments and when you realize your gains can help you reduce your taxable capital gains, but only in a taxable account.

Making your money work for you will only get tougher as capital becomes more expensive and as rate hikes threaten to derail both stocks and bonds. Wringing every drop out of your portfolio’s returns starts with investing tax-efficiently, and that becomes even more important as your tax bracket scales higher. The power of compounding means that even a 1% annual tax drag on your investments can have a massive impact on your returns by the time you retire. As you head into the new year, here are four easy rules to remember:

1. Diversify your investment accounts.

There are two main types of accounts you usually invest with: taxable and tax-advantaged accounts. The former includes brokerage accounts that aren’t subject to preferential tax treatments, while the latter includes investment accounts that are exempt from taxation, allow tax deferment, or some other preferential tax treatment. Individual retirement accounts (IRAs), and 401(k)s in the US, and Individual Savings Accounts (ISAs) in the UK are some examples of tax-advantaged accounts. It can be good to have money in both.

Tax-advantaged accounts typically have annual limits on how much you can deposit and withdraw. But those limits aren’t the only reason to consider diversifying your investment accounts. Your retirement could last for decades, and your spending needs are likely to change over that time. Tax-deferred accounts are great if you expect to be in a lower tax bracket during retirement, while taxable accounts provide you with more flexibility when withdrawing your money.

If you regularly rebalance your portfolio, selling and buying assets to keep to your original allocation, then you might want to make full use of a tax-advantaged account. Or, you could also consider adding new money to underweighted asset classes instead of selling assets to reduce their weighted allocation.

2. Know the trade-offs between different investment vehicles.

Different countries have different tax rules and different types of tax-advantaged accounts, but the principles are broadly the same: tax-inefficient investment types belong in tax-advantaged accounts while tax-efficient investments are best in taxable accounts.

Where tax smart investors typically place their investments. Source: Charles Schwab.
Where tax smart investors typically place their investments. Source: Charles Schwab.

Tax-efficient investments are those that lose less of their returns to taxes – like index funds, low turnover ETFs, passively managed mutual funds, and municipal bonds. On the other hand, actively managed funds that frequently churn their holdings, real estate investment trusts (REITs), and even taxable high-yield bond funds can be extremely tax-inefficient and are best placed in tax-advantaged accounts. Likewise, if you like to trade actively, make sure most of your assets are traded from your tax-advantaged accounts.

You may sometimes need to weigh up the after-tax returns of each investment. In the US for example, municipal bonds are typically exempt from federal taxes but often yield lower pre-tax returns compared to traditional bonds. Depending on your tax bracket, it may make more sense for you to hold municipal bonds in your taxable account as opposed to holding all your bonds in tax-advantaged accounts.

3. Practice buy-and-hold investing.

Typically, the fewer trades you make, the less you’ll pay in taxes. While it isn’t worth holding on to a stock just for the sake of avoiding taxes, you may want to do so in certain instances. In some countries, such as the US, capital gains are taxed differently depending on your holding period. Gains recognized from stocks held for less than a year are taxed at your individual tax rate, which can be as high as 37%. In contrast, taxes on the gains you’ve made from stocks you’ve held for more than a year max out at 20% (plus any additional net investment income tax of 3.8%, if that applies).

Return lost to taxes vs fund fees. Source: Russell Investments.
Return lost to taxes vs fund fees. Source: Russell Investments.

While the UK does not have a capital gains tax system that discriminates based on holding periods, it does provide a capital gains tax allowance, meaning that any profits made up to £12,300 are tax-free. This also implies that you’d do best by reducing churn in your portfolio and limiting your profit-taking to just under the allowance, in order to reduce your tax bill.

4. Consider tax-loss harvesting.

If you do intend to trade frequently or to realize any gains, you can consider offsetting your investment proceeds with your investment losses in a technique called “tax-loss harvesting”. Timing when you sell your losing investments and when you realize your gains can help you reduce your taxable capital gains, but only in a taxable account. If you’re a US investor and your losses are larger than your gains, you could also potentially use those losses to offset up to $3,000 of your ordinary income.

Tax-loss harvesting could save you money. Source: Fidelity.
Tax-loss harvesting could save you money. Source: Fidelity.

However, it’s worth bearing in mind the “wash-sale rule”, which prevents you from harvesting your tax losses if you reinvest your capital from the sale in substantially identical stocks within 30 days before or after the sale. So if you really want to harvest those stock losses, but can’t bear to give up the stock, you may have to take on the added risk of waiting 30 days before repurchasing them.

So what does this all mean for you?

Taxes aren’t the most exciting to think about, but making sure you get them right from the get-go can set you up to maximize your long-term returns. That said, tax efficient investing should be complementary to your investment strategy, and not supersede it. Returns for some assets may look attractive, but less so once you consider their after-tax returns profile so make sure you weigh up the diversification benefit of certain assets to your portfolio versus the resulting tax drag.

The impact of compounded tax drag. Source: Russell Investments.
The impact of compounded tax drag. Source: Russell Investments.

As your income grows over time, you’re probably going to find yourself in a higher tax bracket. And if you’ve maxed out contributions to your tax-advantaged accounts, you’ll want to make sure you load up your taxable investment accounts with mostly tax-efficient investments, like broadly diversified core equity ETFs with low turnover, and limit your trading to investments in your tax-advantaged accounts.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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