This article will discuss the importance of tax-efficient investing in order to maximize portfolio returns. From the different types of tax status at the account level, to tax-efficient investments, we’ll uncover simple strategies to ensure you’re keeping most of your investments returns.
Importance of Tax-Efficient Investing
Taxable, Tax-Deferred or Tax Exempt?
There are 3 differing types of accounts based on tax status. Each can be utilized in different ways in order to be tax efficient.
A taxable account, or brokerage account, has no tax advantages to it. Every time an investor sells an investment with a gain/loss, or an investment earn’s interest or dividends, that investor will pay taxes in that year. Therefore, it’s important to buy investments within a taxable account that are tax efficient. For example, two tax efficient securities are individual stocks and ETF’s. The investor can control when they realize gains/losses using those securities. Whereas with a mutual fund, they cannot. A mutual fund will kick out gains/losses without consent to each individual investor. Meaning it’s impossible to predict when they will do so and an investor’s taxes are unexpectedly affected.
Lastly, if you’re in a high tax bracket, a lot of investors will buy municipal bonds. Municipal bonds pay tax-free interest. Which for someone in the highest tax bracket, provides a high relative after-tax return compared to other investments.
A tax-deferred account doesn’t pay taxes until money is withdrawn. This results in faster growth within the account because taxes aren’t being paid along the way. Examples of a tax-deferred account are 401(k)’s and IRA’s.
A tax-deferred account can take advantage of less tax efficient investments. Because taxes are deferred until withdrawal the investor doesn’t have to worry about unexpected capital gains, interest, or dividends. In general, investments that pay high interest and dividends at the investor’s tax bracket should be “shielded” in a tax-deferred account.
Examples of securities that work best in a tax-deferred account could include the following:
- REITs (Dividends are mostly taxed as regular income)
- High Yield Bonds (high-interest payments taxed at income bracket)
- High turnover stock funds
In contrast, a municipal bond should never be held in a tax-deferred account. The tax benefits of a municipal bond aren’t realized within a tax-deferred account. Therefore an investor would be better off investing in an investment-grade corporate bond, which will offer a higher yield, and benefit from the tax status of the account.
Tax Exempt Account
A tax-exempt account shields investors from paying taxes even at withdrawal. Instead, when investors fund these accounts, the money has already been taxed. For example, if someone funds a Roth 401(k) or Roth IRA, the money they contribute that year to the account is included in their taxable income. As opposed to a traditional 401k or IRA, the money is deducted from their income.
Tax-exempt accounts are very powerful over the long run due to their huge tax benefit. Especially for millennials who may be in the lower tax brackets still, but can expect to earn more as they progress in their careers.
The same tax-efficient investing rules apply to tax-exempt accounts as they do tax-deferred. Tax inefficient securities can be held in this account because they are “shielded” by the accounts tax-exempt status. See the list above for examples.
While all investors can benefit from being tax conscious with their investments, its people in the highest tax brackets that will benefit the most. An investor in the 39% tax bracket will benefit more from being tax efficient on a relative basis compared to an investor in the 20% bracket. Again, everyone can benefit, it’s just more impactful the more you’re subjected to paying taxes. Investors should also take into account, how capital gains can affect their tax bracket, and how to properly plan for them.
Capital gains or losses are realized when a security is sold. For example, if you own a stock and buy it at $100, then turn around and sell it 3 months later for $110, you’d have a realized short-term capital gain. Only when the investment is sold are capital gains realized, and have an effect on taxes. Remember, taxes are only realized in the year an investment is sold if it’s held in a taxable account. Tax-deferred and tax-exempt accounts aren’t subject to getting taxed every year, only at withdrawal or never.
Short-term capital gains (investments held for less than a year) are taxed at the investor’s income tax bracket. Long-term capital gains (investments held for longer than a year) are taxed at 15% or 20%, depending upon the investor income tax bracket. Therefore, investors can take advantage by holding securities for longer than a year and paying less in capital gains taxes.
On the other hand, if an investor has a loss, they can use that loss to offset other gains. An effective way to take advantage of offsetting gains in a portfolio is through tax-loss harvesting. An investor can sell any investments with a loss, immediately buy another investment (just can’t be substantially similar, often done through ETF’s) and buy back their original investment after 31 days. This process accomplishes 2 things:
- Realizes losses in the portfolio to offset current or future capital gains. Therefore the investor won’t have to pay taxes up to a certain amount on their capital gains.
- If the investor still believes the original investment has the potential to grow, they can buy it back after 31 days and potentially at a lower cost basis (purchase price).
Having several types of accounts, each with different tax status’, allows investors to have more flexibility to achieve their financial goals. Especially in retirement. An individual with choices controls their tax bracket from a withdrawal standpoint. If they only had a traditional 401(k) to withdrawal from, they’re forced to pay income taxes. If they have a Roth, 401(k), and a taxable account, it opens up several choices.
Being mindful of the tax status of accounts, and investments within those accounts can potentially increase after-tax returns over time. The general rule of thumb is to hold tax-efficient investments in taxable accounts, and less tax-efficient investments in tax-deferred and tax-exempt accounts. Or assets that have the highest potential return in tax deferred or tax-exempt accounts. The importance of tax-efficient investing can’t be overstated!
Levi Sanchez is a CERTIFIED FINANCIAL PLANNER™, BEHAVIORAL FINANCIAL ADVISOR™ and Co-Founder of Millennial Wealth, a fee-only financial planning firm for young professionals and tech industry employees. He is an avid sports fan, personal finance and investing geek, and enjoys a great TV show or movie. His mission is to help educate his generation about better money habits and provide financial planning services to those who want to start planning for their future today!