Tax-Efficient Investing: A Beginner’s Guide

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Tax-Efficient Investing: A Beginner’s Guide

Every investment has associated expenses. Taxes might be the most painful of all costs, taking the greatest bite out of your earnings. The good news is that tax-efficient investing may reduce your tax burden while increasing your bottom line, regardless of whether you want to save for retirement or create cash.

Key Takeaways

  • Taxes may be one of the most expensive costs and the largest drain on your earnings.
  • When your tax band rises, tax-efficient investment becomes more crucial.
  • Tax-efficient investments should be made in taxable accounts.
  • Non-tax-efficient investments are better suited in tax-deferred or tax-exempt accounts.
  • Annual contribution restrictions apply to tax-advantaged accounts such as IRAs and 401(k)s.

Why Is Tax-Efficient Investing Important?

The Schwab Center for Financial Research examined the long-term impact of taxes and other expenses on investment returns. While investment selection and asset allocation are the most important factors influencing returns, the study discovered that lowering your tax burden has a significant impact as well.

This is due to two factors. One disadvantage is that you lose the money you pay in taxes. The second disadvantage is that you lose the potential growth your money may have created if it had remained invested. Your post-tax returns are more important than your pre-tax returns. After all, it’s your after-tax earnings that you’ll be spending now and in retirement. Tax-efficient investment is essential if you want to optimize your profits and retain more of your money.

Investment Accounts

Tax-efficient investing entails selecting the appropriate assets as well as the appropriate accounts in which to store those investments. Investment accounts are classified into two types:

  1. Taxable accounts
  2. Tax-advantaged accounts

Taxable Accounts

A taxable account is something like a brokerage account. These accounts do not provide tax advantages, but they do have less limits and greater freedom than tax-advantaged accounts such as IRAs and 401(k)s. Unlike an IRA or 401(k), you may take your money from a brokerage account at any time, for any reason, with no tax or penalty.

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If you keep your assets in the account for at least a year, you’ll pay the lower long-term capital gains rate, which is 0%, 15%, or 20% depending on your tax status. If you retain an investment for less than a year, it will be subject to short-term capital gains, which are taxed at the same rate as your regular income.

Tax-Advantaged Accounts

Tax-advantaged accounts are either tax-deferred or tax-free. Traditional IRAs and 401(k) plans, for example, provide an immediate tax advantage. Contributions to these programs may be deductible, providing an immediate tax advantage. When you take money in retirement, you pay taxes, which implies the tax is delayed.

Tax-free accounts, such as Roth IRAs and Roth 401(k)s, operate differently. Contributions to these plans are made after-tax monies, so you don’t get the same tax savings as with standard IRAs and 401(k)s. Your investments, on the other hand, grow tax-free, and eligible withdrawals in retirement are also tax-free. Because of this, these accounts are tax-free.

Tax-Efficient Investing Strategies

Annual contribution restrictions apply to tax-advantaged accounts such as IRAs and 401(k)s. You may contribute a total of $6,000 to your IRAs in 2021 and 2022, or $7,000 if you’re 50 or older (due to a $1,000 catch-up contribution).

In 2021, you may contribute up to $19,500 to a 401(k), or $26,000 if you are 50 or older. The 2022 maximum has been raised to $20,500, or $27,000 with the catch-up contribution. For 2021 and 2022, the total employee/employer contribution cannot exceed $58,000 and $61,000, respectively. With the catch-up payment, these sums rise to $64,500 and $67,500, respectively.

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Because of the tax advantages, it would be ideal to have all of your assets in tax-advantaged accounts such as IRAs and 401(k)s. However, owing to yearly contribution restrictions and a lack of flexibility (non-qualified withdrawals incur taxes and penalties), this is not a viable option for every investor.

Investing in the appropriate account is an excellent approach to enhance tax efficiency. Investments that lose less of their returns to taxes are often better suited for taxable accounts. Investments that lose more of their returns to taxes, on the other hand, are attractive candidates for tax-advantaged accounts.

Investments that generate a high amount of short-term capital gains should be held in a tax-advantaged account.

Tax-Efficient Investments

Most investors are aware that if they sell an investment, they may have to pay taxes on any profits. However, you may be liable if your investment distributes its profits as capital gains or dividends regardless of whether you sell it or not.

Some investments are more tax-efficient than others by definition. Tax-managed funds and exchange traded funds (ETFs), for example, are more tax-efficient among stock funds since they generate less capital gains. Actively managed funds, on the other hand, purchase and sell shares more often, potentially generating greater capital gains dividends (and more taxes for you).

Another example is bonds. Municipal bonds are very tax-efficient since interest income is not taxable at the federal level and is often tax-free at the state and municipal levels as well. Because of this, Munis are frequently referred to be triple-free. Because they are already tax efficient, these bonds are ideal for taxable accounts.

Treasury bonds and Series I bonds (savings bonds) are also tax-efficient since they are not subject to state or local income taxes. However, since corporate bonds do not have any tax-free clauses, they are better suited in tax-advantaged accounts.

  Tax Refund Definition

Here’s a list of places where tax-averse investors could deposit their money:

Taxable Accounts (e.g., brokerage accounts)Tax-Advantaged Accounts (e.g., IRAs and 401(k)s)
Individual stocks you plan to hold for at least a yearIndividual stocks you plan to hold for less than a year
Tax-managed stock funds, index funds, exchange traded funds (ETFs), low-turnover stock fundsActively managed stock funds that generate substantial short-term capital gains
Qualified dividend-paying stocks and mutual fundsTaxable bond funds, inflation protected bonds, zero-coupon bonds, and high-yield bond funds
Series I bonds, municipal bond fundsReal estate investment trusts (REITs)

Many investors maintain both taxable and tax-advantaged accounts in order to take advantage of the advantages that each account type provides. Of course, if you just have one sort of investment account, you should concentrate on investment selection and asset allocation.

The Bottom Line

Tax minimization is a fundamental element of investing (whether for retirement or to create income). Holding tax-efficient assets in taxable accounts and less tax-efficient investments in tax-advantaged accounts is an excellent tax-saving approach. This should offer your accounts the greatest chance of growing over time.

Of course, even though it is preferable to retain an investment in a tax-advantaged account, there may be times when you must put something else above taxes. A corporate bond, for example, may be better suited for your IRA, but you may elect to keep it in your brokerage account for liquidity purposes. Furthermore, since tax-advantaged accounts have stringent contribution limitations, you may be forced to maintain some assets in taxable accounts, even if they would be better suited in your IRA or 401(k) (k).

Always seek the advice of a certified investment planner, financial counselor, or tax professional to determine the optimal tax approach for your specific position and objectives.

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