Look: If you’re not applying tax-saving strategies to your investment strategy, you could be seriously shortchanging your investments.
That’s right! According to the Schwab Center for Financial Research which evaluated the long-term impact of taxes on investment returns, while investment selection and asset allocation are the most important factors that affect returns, minimizing taxes also has quite a significant effect.
Of course, investment decisions shouldn’t be driven solely, or even primarily, by taxes - that’s the job of your financial goals, taking into account your risk tolerance and investment timeline - but it makes financial sense to take advantage of opportunities to reduce, defer or manage taxes where possible.
Why do I say this?
Because when you are tax-efficient in your investment approach you:
- Save money that you would have otherwise paid in taxes
- Allow the saved money to work for you and make you even more money through the compounding effect. And believe me, compound interest is a friend you want working for you.
Related: How compound interest works for you
Imagine that! It is possible to save hundreds of thousands of dollars over your investment career just by strategically planning out your investments to take advantage of the extent that the tax code allows.
Now let's get the show on the road. I’ll get into more detail about what tax-efficient investing is, tax-advantaged accounts, and tax-efficient investment strategies.
Tax Efficient Investing Explained
What is Tax-Efficient Investing?
As the name suggests, tax-efficient investment strategies aim to eliminate, reduce or defer the taxes associated with investments. This keeps more money in your account which in turn allows faster growth of your nest egg through compounding.
By and large, these are the main taxes associated with investments:
- Taxes on realized capital gains (short-term if held under a year or long-term if over)
- Taxes on dividends
- Taxes on bond interest
- Taxes on rent from real estate investments
Tax-efficient investing strategies are two-faceted for the most part: Investing in the right accounts - tax-advantaged accounts - this is the most familiar path to investment tax benefits; and placing the right investments in the right accounts.
But more on the latter later. For now, let's learn more about tax-advantaged accounts.
Investment Account Types
There are 2 types of investment accounts:
- Tax-advantaged accounts
- Taxable accounts
1. Tax-advantaged Accounts
You might have guessed it - A tax-advantaged account is any investment account that offers some kind of tax benefit. They are primarily made up of retirement accounts.
They fall into two main categories: tax-deferred (pre-tax) tax-exempt or tax-free (after-tax).
Tax-deferred accounts allow you to realize immediate tax deductions on the full amount of your contribution, but future withdrawals from the account will be taxed at your ordinary-income tax rate.
1. Employer-sponsored retirement accounts - 401(k) & 403(b) plans
Now before we get any further - has anyone else ever wondered why the name 401(k)? I used to think it was something fancy, but turns out it’s simply named after section 401(k) - the section of the U.S. tax code that created them.
Now with that mystery out of the way, let’s get to the heart of it.
You should absolutely be investing in your employer-sponsored account. Here’s why.
Say you earn $5000 per month and have a federal income tax rate of 20%, your monthly federal taxes would be $1000.
- Contributions reduce your taxable income.
If you instead contributed $500 toward your retirement account, you would be left with $4500 taxable income, 20% of which is $900. You would save $100 in taxes, plus have $500 in your account working for you!
Speaking of money working for you, the contributions in your account would grow without having any taxes levied on them. This means that whenever a position has any capital gains or pays interest or dividends, you wouldn’t need to pay any taxes for it. You would only need to pay taxes upon withdrawal.
- Contributions grow tax-free.
- Free money through your employer match.
Hello? Can it get any better than this?!
Many companies match 50% to 100% of employees’ contributions to retirement accounts up to a certain percentage of their salary as part of their employee benefits package. This is quite simply free money that you shouldn’t be leaving at the table.
2. Traditional IRA
This is similar to the employer-sponsored 401(k) and 403(b) accounts with the main difference being that they are self-directed as opposed to being employer-directed.
You’d be right to think then that contributions here grow tax-deferred and that they reduce your taxable income.
News flash: HSAs have triple tax benefits.
That’s right! They have pre-tax contributions, tax-free earnings, and tax-free withdrawals (for qualified health-related expenses).
HSAs are supercharged tax-sheltered investment accounts that help you put money away for health-related expenses. What’s more, after retirement, money in HSA accounts can be used for anything, not just medical expenses (but keep in mind that non-qualified withdrawals - that is non-health-related - are subject to taxation). In this way it acts like a traditional IRA.
As if that isn’t enough, with a HSA, you can use out-of-pocket money to pay for medical bills now, then claim the amount from your HSA account later when you are older. This way, you allow the money in your HSA to grow tax-free.
Whoa! Talk about benefits.
Now let’s talk about tax-exempt accounts. These accounts provide future tax benefit - withdrawal at retirement is not subject to tax.
1. Roth IRA
The Roth IRA is almost identical to the traditional IRA, save one not-so-little detail: the backloading of tax benefits.
What does this mean?
Whereas with the traditional IRA, you make pre-tax contributions to a retirement account then experience taxed withdrawals, with a Roth IRA, you make after-tax contributions but your withdrawals are not taxed.
Ok, I’ll say that again -
Once you hit 59.5 years, your Roth IRA withdrawals are 100% tax-free!
What’s more, as we have come to see with tax-advantaged accounts, your contributions grow tax-free.
2. 529 College plan
529 plans are designed specifically for any qualified educational expenses for yourself or your children, and get this - they can be opened even before your children are born!
Fascinating isn’t it?
While contributions are made after-tax, returns accumulate tax-free, and qualifying withdrawals are also tax-free!
3. Roth 401(k) / 403(b)
If you think these are similar to the 401(k) and 403(b) plans, you are right!
Like the Roth IRA, however, these too backload the tax-benefits. That means that contributions into the accounts are made after-tax, then returns accumulate tax-free, and withdrawals are also tax-free after you retire.
You might be wondering who this type of account is suited for?
This type of retirement account is well-suited for those who think they'll be in a higher tax bracket in retirement than they are now.
So to recap, here are the key difference between tax-exempt and tax-deferred accounts:
Tax-free growth of investments
Tax-free growth of investments
Tax-free qualified withdrawals
2. Taxable Accounts
A brokerage account is an example of a taxable account. Taxable accounts have no tax benefits, but they may be more flexible than tax-advantaged accounts. For example, unlike with 401(k) or IRAs, you can withdraw your money from a brokerage account at any time.
Tax-Efficient and Tax-Inefficient Assets
Ok, so now that you are familiar with tax-advantaged accounts, you might be wondering what next. It is important to understand how various investment assets are taxed to determine how tax-efficient or tax-inefficient they are.
More often than not, the most tax-efficient assets have lower returns, slower growth and are low yielding. On the other hand, tax inefficient assets have significant capital gains and high dividends. Frequency of trading also impacts the tax efficiency of an asset with highly traded assets being less tax efficient.
The Right Investments in the Right Accounts
Tax-inefficient assets should go in the tax-advantaged accounts where your compounding money can be protected from hefty tax haircuts, whereas tax-efficient assets which don’t require sheltering can go into taxable accounts.
High-frequency traded positions held for less than a year
Less frequency traded positions held for more than a year
High-dividends paying positions eg. REITs, Non-qualifying dividend-paying stocks
Qualified dividend-paying stocks and mutual funds
Actively managed funds with substantial short-term capital gains
Tax-managed stock funds, index funds and ETFs which seldom distribute capital gains
High yielding index funds
Low yielding index funds
High-yielding bonds with high-interest rates
Short-term, low-interest bond fund
You’re robbing yourself of some good hard-earned money if you are not practicing tax-efficient investing. It is quite simply time to stop leaving money on the table.
Take the first step by applying one tax-saving strategy to start with. Start by investing in your retirement accounts then go from there.