Tax-Efficient Investing Strategies: A Guide on Taxes & Investment Management

You’ve worked hard to build your investment portfolio, and watching it grow can be incredibly satisfying. But then you remember there’s an uninvited guest at the investment party: taxes. Every time you sell an investment at a profit or receive a dividend, Uncle Sam wants his share. While you can’t (and shouldn’t!) avoid paying taxes, you can make strategic decisions to help maximize your after-tax returns.

Understanding tax-efficient investing can make a significant difference in your long-term financial success. Let’s explore how to make your investment portfolio work smarter when it comes to taxes so you can stop worrying about the taxman and get back to celebrating your wins. 

Understanding Your Investment Accounts

The two broad classifications  of investment accounts that we will look at for the purposes of this article are: taxable accounts and tax-advantaged accounts. Understanding the difference between the two will help foster a deeper understanding of investment strategies. 

Taxable Accounts

These standard brokerage accounts offer complete flexibility with contributions and withdrawals, but they come with regular tax obligations. Interest earned, dividends, and capital gains are all taxable events. When you earn interest or receive non-qualified dividends, you’ll pay taxes at your ordinary income tax rate based on your individual tax bracket. For certain qualified dividends and long-term capital gains, you’ll generally pay at the standard capital gains rate, which ranges from 0% to 20% depending on your income bracket.

Tax-Advantaged Accounts

When we talk about long-term planning with tax-advantaged accounts, we’re typically referring to retirement accounts like 401(k)s and IRAs. Your contributions to a 401(k) are deducted from your wages for income tax purposes. Your contributions to an IRA may be deductible, but it’s possible you will be ineligible for a deduction if you make too much money. The decision is also impacted by your ability to contribute to a work-sponsored retirement plan. Reference the IRS guidance on the IRA deduction limits to see where you stand.

These traditional retirement accounts let you defer taxes throughout your working years. However, once it comes time to replace your paycheck and you need to withdraw from your accounts, every single dollar will be taxed at ordinary income rates. While people expect their tax bracket to be much less in retirement, for many people that save everything in these traditional accounts, we find they’re often not far off from their working years.

Then you have our beloved Roth accounts, such as a Roth 401(k) or a Roth IRA. Since you don’t get a tax break up front with these accounts, any growth you have will be tax-free. Even with contribution limits and withdrawal restrictions, these accounts are some of the best tools for tax-efficient investing. 

Tax-advantaged accounts can also include more restrictive accounts such as 529 Plans or Health Savings Accounts (HSAs). They are certainly worthy of consideration, but due to their specific use cases and contribution limits, we do not see them being as impactful as the more retirement-minded accounts.

Tax-Efficient Investing Strategies & Considerations

Once you understand the investment options available to you, you can begin to use tax-efficient investing strategies to further maximize your wealth-building. Let’s take a look at a few strategies to consider. 

• Capital Gains

  • One of the most straightforward ways to reduce your tax burden is being strategic about when you sell investments. Holding investments for more than a year qualifies you for long-term capital gains rates, which are typically much lower than short-term rates that are taxed as ordinary income.
  • For example, if your ordinary income tax bracket is 32%, and you sell an investment with a $10,000 gain after only holding it for 11 months, you could owe $3,200 in taxes. Hold that same investment for 13 months, and your tax bill might drop to $1,500-$2,000 because of lower long-term capital gains rates. 

• Tax Diversification

  • It pains us to see people that have worked their whole lives to save and invest for a comfortable retirement, but then they still end up pinching pennies in their golden years. This is exactly what happens when people save every last dollar in a Traditional 401(k) or Traditional IRA.
  • For example, if you want a new $40,000 car, you can’t just withdraw $40,000 from your account and drive off the lot. You also need to be mindful of the taxes owed on your withdrawal. So in this instance, you may need to withdraw an additional $10,000 – $12,000 to cover the taxes for your car purchase.
  • Even when people can afford the taxes without a problem, we still see this being a mental roadblock for people to enjoy their money. They second guess each car purchase, home renovation, and family trip because they are seeing plain as day how much more those expenditures are going to cost them in taxes
  • This is where diversifying the type of account you use can be helpful. For some people that means converting to Roth accounts in lower-income years. For others it simply means building up savings in a standard taxable account that has access to lower capital gains tax rates.
  • Being able to have some level of control over your taxation in retirement can be extremely helpful when it comes time to actually enjoy your money. 

• Qualified Dividends

  • When building an income-focused portfolio, consider prioritizing qualified dividends when possible. Qualified dividends, typically paid by U.S. companies and certain foreign corporations, are taxed at the lower capital gains rate rather than your ordinary income rate. This tax advantage makes them particularly valuable in taxable accounts.
  • To qualify for the lower tax rate, you generally must hold the dividend-paying investment for more than 60 days during a 121-day period centered on the ex-dividend date. Understanding these requirements and planning your holding periods around them can lead to meaningful tax savings.

• Tax-Loss Harvesting

  • Market downturns, while challenging, can present tax-saving opportunities. By strategically selling investments at a loss, you can offset capital gains and reduce your tax bill. You can even use up to $3,000 of excess losses to offset ordinary income each year, carrying forward any additional losses to future tax years.
  • Tax-loss harvesting can take some time to understand, and you’ll want to get clear on the rules to follow when buying back similar investments to the ones you sold. You can read more about tax-loss harvesting here. 

• Asset Location

  • Think of your investment accounts as different boxes, each with its own tax treatment. By strategically placing investments in the most tax-appropriate accounts, you can minimize your overall tax burden. When you have a mix of taxable and tax-advantaged accounts, you can adjust your investments accordingly.

• Municipal Bonds

  • Municipal bonds, often called “munis,” are debt securities issued by state and local governments to fund public projects like schools, highways, and hospitals. These bonds offer a unique tax advantage: the interest income is typically exempt from federal taxes, and in some cases, it’s also free from state and local taxes if you reside in the issuing state.
  • For investors in higher tax brackets, municipal bonds can be a smart choice to generate income while keeping tax liabilities low. They’re particularly attractive for those seeking steady returns with minimal risk. While the yields on municipal bonds are often lower than those of taxable bonds, the tax-equivalent yield can be competitive, making them a valuable component of a tax-efficient portfolio.

The Intersection of Planning & Investment

Tax-efficient investing strategies are powerful on their own, and they become even more effective when you incorporate them into a larger, comprehensive financial plan. Your investment decisions don’t exist in a vacuum – they should reflect your broader financial picture, including your income needs, retirement timeline, charitable goals, and estate planning objectives.

Let’s look at a common scenario: imagine you’re approaching retirement with a significant portion of your wealth tied up in your employer’s company stock. While the stock has performed well, holding a concentrated position creates both investment risk and tax implications. A purely investment-focused approach might suggest selling quickly to diversify, but this could trigger a substantial tax bill.

Instead, a holistic planning approach might recommend ideas like these:

• Utilizing a donor-advised fund to offset gains with charitable deductions.
• Strategically selling portions of the portion over several tax years.
• Incorporating the stock into your estate planning through gifting strategies.
• Considering whether to exercise stock options or restricted stock units in stages.

The most successful tax-efficient investing decisions should be guided by your comprehensive financial plan. Sometimes, this might mean temporarily accepting a less-than-optimal tax situation to achieve more important financial goals, or timing investment moves to align with major life transitions like retirement, relocation, or business sales. 

Beyond Tax Minimization

While tax efficiency is important, it shouldn’t be your only consideration. First and foremost, your investment strategy should align with your financial goals, risk tolerance, and time horizon. Sometimes paying taxes is simply the cost of making a smart investment decision.

Here are just some of the factors to consider, aside from taxes, when making investment decisions:

• Overall portfolio diversification
• Expected return potential
• Investment costs and fees
• Liquidity needs
• Risk management

Remember, a coordinated planning and investment approach can help reduce investment risk, manage taxes more efficiently, fulfill charitable goals, and create a lasting legacy – all while maintaining the retirement lifestyle you want.

Final Thoughts

Remember, tax-efficient investing is a long-term strategy that requires regular monitoring and adjustments. As tax laws, market conditions, and your personal circumstances change, you’ll need to update your approach.

Working with a financial advisor who understands both investment management and tax strategy can help you navigate these decisions while keeping your overall financial plan on track. They can also help you balance tax efficiency with other important factors like risk management and return potential.

At SK Wealth, our financial advisors have been helping clients navigate tax-efficient investing strategies for 25 years. Through our Integrated Financial Advantage™ process, we create personalized recommendations that align with your goals while keeping an eye on tax efficiency, helping you live with intention, tomorrow and today.

Click here to find out more about SK Wealth’s specialized financial planning and investment management services.