Investing is tricky on so many levels. You have to figure out what to invest in, how long to invest in it, and how much you need to invest to reach your goals.
To make matters more complicated, you often have to deal with taxes on your earnings.
There are various types of investment accounts that provide tax advantages while some do not.
If you make the right decisions, the type of account you choose can help cut down on taxes paid on profitable investments. Certain types of investments are better suited for certain accounts.
Tax efficiency may not seem like a big deal. However, it can help you optimize your returns. This allows you to have more money when you retire.
Understand the reason for tax efficient investing and how you can use it to your financial advantage.
What Is Tax Efficient Investing?
Tax efficient investing is the concept of making smart investment decisions while keeping their tax impacts in mind.
Thinking about how to minimize the taxes you’ll owe on your investments.
This approach can take many forms:
- Choose investments that minimize the amount of taxes you might owe.
- Put the correct investments in the right type of investment accounts. This can help optimize the overall amount of taxes you’ll pay.
- Take part in transactions called tax loss harvesting, which can potentially lower the taxes you’ll owe in a given year.
Taxable Accounts vs. Tax-Deferred Accounts
An important concept to master for tax-efficient investing is the types of accounts you can use to invest.
Your usual brokerage account is called a taxable investment account. It has no tax benefits. All investment income you earn is subject to investment taxes.
There are tax-advantaged accounts.
In general, there are two common types of these accounts that revolve around retirement. (There are others, as well, but we're focusing on the ones that you're most likely to use.)
The first type is considered a traditional tax-advantaged account. You may get a federal income tax deduction today for contributions to these accounts.
Investments and their earnings in these accounts grow tax-free.
You have to pay ordinary income taxes on withdrawals from the account after you reach retirement age.
Traditional IRAs and 401(k)s are the most popular examples.
With Roth retirement accounts, you do not get a tax break now for contributing to these accounts. Instead, your investments and their earnings grow tax-free.
The best part:
When you withdraw the money after reaching retirement age, you don’t pay taxes then.
Roth IRAs and 401(k)s are the most popular examples.
Taxes You May Have to Pay as an Investor
Getting a tax bill for transactions related to your investments is part of life.
Unfortunately, it’s a part of life many people don’t realize. When they do, it’s too late to make tax-efficient choices.
If you figure this out before you start investing, it’s easier to invest more efficiently. Then, you can achieve a lower tax liability.
We’ll focus mostly on federal taxes you pay on your investments.
States may also tax your investments. Each state has different laws.
Check with your tax preparer for more details about state taxes that may impact you.
In general, you pay taxes when you receive income from your investments. This most commonly happens in the form of dividends and interest income.
You can also pay taxes when you eventually sell your investments. However, this usually only happens when you sell your investment for a gain.
Here are the most common investment-related taxes:
Dividends are payments to shareholders. People that own stocks, mutual funds and ETFs might end up receiving dividend payments.
Not all stocks pay dividends. To completely avoid this tax, only invest in companies that don’t pay dividends.
Many companies do end up paying out dividends, though. This means if you own broad market index funds, you’ll probably receive some dividend income.
Depending on how long you’ve owned an investment, your dividend income can either be qualified or unqualified.
Qualified dividend income is taxed at a lower rate than unqualified income.
In general, you must have owned the investment for more than 60 days to count as qualified dividend income.
Qualified dividend income is taxed at 0%, 15% or 20% depending on your taxable income.
Unqualified dividend income is taxed at your ordinary income tax rate. Currently, that could be as high as 37%.
You can defer the dividend tax income by putting these investments in a tax-advantaged account.
As long as your dividends stay in the tax-advantaged account, they stay tax advantaged.
That means traditional retirement accounts won’t generally tax the money until you withdraw it in retirement.
Roth retirement accounts normally won’t pay taxes on the dividends as long as they’re withdrawn after full retirement age.
Capital gains tax
Capital gains are the taxes you pay when you sell your investment for more than you paid for it.
There are two different types of capital gains tax rates:
- long-term capital gains taxes
- short-term capital gains taxes
Figuring which you pay depends on how long you’ve owned your investment for.
You pay long-term capital gains taxes if you owned the investment for more than a year. These rates are 0%, 15% or 20% depending on your taxable income.
You pay short-term capital gains taxes if you owned the investment for a year or less. This tax is the same as your ordinary income tax rate.
You can avoid capital gains tax in a couple of ways.
- You won’t usually pay this tax if you sell your investment for less than you purchased it for.
- You can avoid capital gains taxes by purchasing your investments in a Roth account. These accounts don’t give you a tax break up front. The benefit is you don’t have to pay any taxes on the investments when you withdraw the money in retirement.
One way to offset some of your capital gains earned in a year is tax loss harvesting.
This concept requires you to sell investments you hold that are currently worth less than you purchased them for. These tax losses may offset your tax gains.
You have to be careful with tax loss harvesting, though.
You can’t repurchase the same or substantially equivalent investment within 30 calendar days before or after the sale. If you do, it may become a wash-sale. Wash-sale rules may disallow the loss.
Interest income tax
Interest income is a bit easier to understand. You can earn this type of income from:
- Your bank account
- Certificates of deposit (CDs)
- Money market accounts
You might earn this income from ETFs or mutual funds, as well. It depends on what investments they hold.
This income can be avoided in the short term by using traditional retirement accounts such as 401(k)s.
It can normally be completely avoided if the investment that pays the interest income is held in a Roth IRA and the money is withdrawn at or after full retirement age.
The Medicare surtax applies to certain types of investment income. In particular, it applies to high-income taxpayers.
The tax rate is 3.8% on your net investment income.
You might owe this tax if your modified adjusted gross income exceeds $200,000 as a single or head of household filers. The limit increases to $250,000 for married filing jointly taxpayers.
Money held in tax-advantaged retirement accounts is not usually subject to this tax.
Do Tax-Exempt Investments Exist?
There are certain types of investments that may be exempt from taxes. That said, it is highly dependent on your specific situation.
The biggest factor:
Your official place of residence.
Municipal bonds, or bonds issued by state, city or local governments, might fall into this category for you.
Income from municipal bonds is not taxed on the federal level. Depending on where you live and which municipality issued the bond, they may not be taxed at the state or local level either.
Check with your tax preparer or financial advisor before buying a municipal bond as a tax-exempt investment. These professionals should be able to advise you of the tax impacts for your situation.
Tax Efficient Investments
Tax efficient investments are those that require you to pay as little tax as possible. Tax efficient investments may work best in a taxable investment account.
Investments that put off little income and won’t have huge capital gains are typically your lower risk investments.
Keeping these in a taxable account while putting your assets that pay out higher income and offer higher potential gains in tax-deferred accounts can minimize your overall tax liability.
This assumes you’ve maxed out your retirement account options, first.
If you haven’t, it might make sense to keep all of your investments in a tax-deferred account.
Just make sure you won’t need the money until retirement.
Tax Inefficient Investments
Since interest income is taxed at your ordinary income tax rate, investments that pay high interest rates may be considered less efficient.
If you’re investing in a taxable investment account, investments that pay dividends may be considered inefficient, as well. This is because you’ll have to pay taxes every year a dividend is paid even if you reinvest the dividends.
Ultimately, your goal will likely be to put tax inefficient investments in tax-advantaged retirement accounts.
Those that provide a high investment return over the long-term may fit best in a Roth account since you don’t pay taxes on withdrawals in retirement.
The Big Picture
When you look at tax efficient investing on a high level, you’re probably wondering what types of investments should go in each account type.
Since more aggressive investments should appreciate the most over the long term, it often makes sense to put these in tax-advantaged accounts. This may include stocks, high-yield bonds and stock mutual funds or ETFs.
Lower-return and less aggressive investments won’t result in as high of a tax burden over the long term. This may include cash and conservative bond investments.
For that reason, these less aggressive investments should likely go in your taxable accounts assuming your tax-advantaged accounts are maxed out.
Each person’s situation is unique. You need to examine your investment strategy as a whole to see if these ideas make sense for you.
Ask a pro
Consult a professional to work toward making your investments more tax efficient.
While tax efficiency is great, there may be other considerations to take into account.
These advisors look at the big picture, including tax efficiency.
Financial professionals can help you with the intricacies of your specific situation.
Tax preparers can help you understand the impact on your tax returns.
Advisors can help you come up with an investment strategy, too. The strategy should detail which types of investments you should hold in each type of account. Then, you just have to implement the strategy or hire the professional to do it for you.