Every investment has costs. You may have expenses, such as commissions, fees, administrative costs, and taxes, on top of your original investment amount. Taxes, though, can sting the most out of all the expenses, taking the biggest bite out of your returns. But don't fret, because there is good news. Tax-efficient investing can minimize your tax burden and maximize your bottom line—whether you want to save for retirement or generate cash.
Key Takeaways
- Taxes can be one of the biggest expenses and take the biggest bite out of the returns on your investments.
- Tax-efficient investing becomes more important when your tax bracket is higher.
- Investments that are tax-efficient should be made in taxable accounts.
- Investments that aren't tax-efficient are better off in tax-deferred or tax-exempt accounts.
- Tax-advantaged accounts like IRAs and 401(k)s have annual contribution limits.
Why Is Tax-Efficient Investing Important?
Investment selection and asset allocation are the most important factors that affect investment returns. But also, minimizing the amount of taxes you pay can have a significant effect and long-term impact on returns.
There are two reasons for this:
- You lose the money you pay in taxes.
- You lose the growth that money could have generated if it were still invested.
Your after-tax returns matter more than your pre-tax returns. After all, it's those after-tax dollars that you'll spend now and in retirement. If you want to maximize your returns and keep more of your money, tax-efficient investing is a must.
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Types of Investment Accounts
Tax-efficient investing involves choosing the right investments and the right accounts to hold those investments. There are two main types of investment accounts: Taxable accounts and tax-advantaged accounts.
There are advantages and disadvantages to each kind of account. Both account types are important parts of creating an investment strategy. We've highlighted some of the key characteristics about both below.
Taxable Accounts
Taxable accounts don’t have any tax benefits. One example of this kind of account is a brokerage account.
Although there may be no benefits related to taxation, there is a trade-off. They offer fewer restrictions and more flexibility than tax-advantaged accounts such as individual retirement accounts (IRAs) and 401(k)s. Unlike an IRA or a 401(k), you can withdraw your money at any time, for any reason, with no tax or penalty from a brokerage account.
How the returns from these accounts are taxed depends on how long you have held an asset when you choose to sell it. So:
- If you hold investments in the account for over a year, you'll pay the more favorable long-term capital gains rate of 0%, 15%, or 20%, depending on your tax bracket.
- If you hold investments in the account for a year or less, they will be subject to short-term capital gains. This is the same as your ordinary income tax bracket.
Tax-Advantaged Accounts
Tax-advantaged accounts are generally either tax-deferred or tax-exempt. Tax-deferred accounts, such as traditional IRAs and 401(k) plans, provide an upfront tax break. You may be able to deduct your contributions to these plans, which provides an immediate tax benefit. You pay taxes when you withdraw your money in retirement, which means the tax is deferred.
Tax-exempt accounts, including Roth IRAs and Roth 401(k)s, work differently. Contributions to these plans are made with after-tax dollars, so you don't receive the same upfront tax break that you do with traditional IRAs and 401(k)s. However, your investments grow tax-free and qualified withdrawals in retirement are tax-free as well. That's why these accounts are considered tax-exempt.
The trade-off for the tax benefits of these accounts is the restrictions that come with when and how you can withdraw money from them. In most circ*mstances, if you are below retirement age when you make withdrawals, you will have to pay taxes and/or penalties.
Tax-Efficient Investing Strategies
Tax-advantaged accounts like IRAs and 401(k)s have annual contribution limits. In 2023, you can contribute a total of $6,500 to your IRAs, or $7,500 if you're age 50 or older (because of a $1,000 catch-up contribution.) In 2024, the regular contribution limit increases to $7,000. The catch-up limit is still $1,000, so you can contribute a total of $8,000 if you are age 50 or older.
With 401(k)s, you can contribute up to $22,500 in 2023, or $30,000 with the catch-up contribution. The combined employee/employer contribution can't exceed $66,000 for 2023. This increases to $73,500 with the catch-up contribution.
In 2024, you can contribute up to $23,000 or $30,500 with the catch-up contribution. The combined employee/employer contribution can't exceed $69,000 for 2024. This increases to $76,500 with the catch-up contribution.
Because of the tax benefits, it would be ideal if you could hold all your investments in tax-advantaged accounts like IRAs and 401(k)s. But due to the annual contribution limits—and the lack of flexibility (non-qualified withdrawals trigger taxes and penalties)—that's not practical for every investor.
A good way to maximize tax efficiency is to put your investments in the right account. In general, investments that lose less of their returns to taxes are better suited for taxable accounts. Conversely, investments that tend to lose more of their returns to taxes are good candidates for tax-advantaged accounts.
Investments that distribute high levels of short-term capital gains are better off in a tax-advantaged account.
Tax-Efficient Investments
Most investors know that if you sell an investment, you may owe taxes on any gains. But you could also be on the hook if your investment distributes its earnings as capital gains or dividends regardless of whether you sell the investment or not.
By nature, some investments are more tax-efficient than others. Among stock funds, for example, tax-managed funds and exchange traded funds (ETFs) tend to be more tax-efficient because they trigger fewer capital gains. Actively managed funds, on the other hand, tend to buy and sell securities more often, so they have the potential to generate more capital gains distributions (and more taxes for you).
Bonds are another example. Municipal bonds are very tax-efficient because the interest income isn't taxable at the federal level and it's often tax-exempt at the state and local level, too. Munis are sometimes called triple-free because of this. These bonds are good candidates for taxable accounts because they're already tax efficient.
Treasury bonds and Series I bonds (savings bonds) are also tax-efficient because they're exempt from state and local income taxes. But corporate bonds don't have any tax-free provisions, and, as such, are better off in tax-advantaged accounts.
Here's a rundown of where tax-conscious investors might put 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 year | Individual stocks you plan to hold for less than a year |
| Tax-managed stock funds, index funds, exchange traded funds (ETFs), low-turnover stock funds | Actively managed stock funds that generate substantial short-term capital gains |
| Qualified dividend-paying stocks and mutual funds | Taxable bond funds, inflation protected bonds, zero-coupon bonds, and high-yield bond funds |
| Series I bonds, municipal bond funds | Real estate investment trusts (REITs) |
Many investors have both taxable and tax-advantaged accounts so they can enjoy the benefits each account type offers. Of course, if all your investment money is in just one type of account, be sure to focus on investment selection and asset allocation.
What Does Tax Efficient Investing Mean?
Tax efficient investing is a strategy that helps you maximize your returns by limiting any losses to taxes. This means your tax burden is lower when you seek out tax-efficient investments. It's a good idea to review the tax obligations associated with different accounts before you make the decision to invest in them. If you have any doubts or questions, be sure to consult a financial or investment professional to help you.
What Are the Tax Benefits of a 401(k)?
One of the main tax advantages of a 401(k) plan is how contributions are treated. Contributions to a 401(k) are made with pre-tax dollars. This lowers your taxable income for the year, which means you may end up with a lower tax bill. Keep in mind that you must remain within the limits set out each year, otherwise, you will be subject to fees and taxes.
How Much Can I Contribute to my 401(k) in 2023?
There are limits to how much you can contribute to your 401(k) each year. For 2023, you're allowed to deposit $22,500 into your 401(k). You can contribute an additional $7,500 if you are 50 or over. The amount increases to $23,000 in 2024 but the catch-up contribution for people 50 and over remains the same at $7,500.
The Bottom Line
One of the core principles of investing (whether it's to save for retirement or to generate cash) is to minimize taxes. A good strategy to minimize taxes is to hold tax-efficient investments in taxable accounts and less tax-efficient investments in tax-advantaged accounts. That should give your accounts the best opportunity to grow over time.
Of course, even if it's better to keep an investment in a tax-advantaged account, there may be instances when you need to prioritize some other factor over taxes. A corporate bond, for example, may be better suited for your IRA, but you may decide to hold it in your brokerage account to maintain liquidity. And since tax-advantaged accounts have strict contribution limits, you may have to hold certain investments in taxable accounts, even if they'd be better off in your IRA or 401(k).
Always consult with a qualified investment planner, financial advisor, or tax specialist who can help you choose the best tax strategy for your situation and goals.
