What Is Tax Efficiency? Key Strategies to Minimize Taxes on Investments

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As an investor, you’ll want to pay close attention to the taxes you have to pay on your investments. And you’ll want to find ways to legally minimize, defer or even get rid of your tax liability on any gains — a process known as tax efficiency.

Tax efficiency can give you more money for your own financial goals.

How Tax Efficiency Works

Tax efficiency is when an investor or business owner pays the least amount of taxes possible to the Internal Revenue Service. This allows them to increase their income or gains, while reducing their overall tax bill. It’s a smart tactic that should be part of any investment strategy if the goal is to legally reduce taxation.

Just like your regular income, the IRS can tax income earned from an investment portfolio. The way it taxes investment income is different from your employment wages, however. Not only is your investment income assessed differently, but you could be taxed at a different rate.

Generally speaking, investment income is taxed in one of the following ways:

• Cash, interest or dividends: Cash income, dividends or interest received during the tax year is typically subject to taxes for that year.
• Capital gains: Capital gains are when an asset — like stocks or real estate — increases in price. You’ll generally only be subject to capital gains tax when you realize those gains, such as when you sell that asset.
• Other distributions: Distributions from certain types of accounts, such as mutual funds, may also be taxed.

These are known as taxable events. Making an investment portfolio tax efficient minimizes taxable events. One way to do this is to restructure the taxable accounts so that they’re taxed at a lower rate than they would have been otherwise.

For example, an investor could open a tax-advantaged Individual Retirement Account (IRA). If they have gains and dividends reinvested, these earnings can continue to grow over time without being taxed. They’ll only be subject to taxation upon withdrawal.

IRAs aren’t the only type of tax-efficient account. Other common options include annuities and 401(k) retirement plans. Tax-efficient mutual funds, which are taxed at a lower rate than standard mutual funds, may also be an option for tax efficiency planning.

Note that not all income-producing accounts are tax efficient, and some are taxed differently than others. Certain accounts are tax-deferred, meaning the money grows tax-free until withdrawn. Others — like Roth IRAs — require the investor to pay taxes upfront. The tradeoff is any qualified withdrawals are tax-free.

Why Tax Efficiency Matters for Investors

As an investor, tax efficiency is key to getting the most out of your investments. It minimizes how much you pay to the IRS, maximizing your returns and making it easier to achieve your financial goals. Even if you don’t have a ton of taxable investments yet, understanding how tax efficiency can impact your bottom line is crucial.

Say you’re in debate between opening a Roth IRA and a Traditional IRA. Both are tax-advantaged, but in different ways.

• Traditional IRA: You’re contributing pre-tax money, meaning you can take any contributions as a deduction for the tax year they’re made. This lowers your Adjusted Gross Income (AGI) and reduces that year’s income tax and could qualify you for certain tax incentives. However, withdrawals are usually taxed.
• Roth IRA: You’re contributing after-tax money, meaning you can’t take a deduction from your annual income. Withdrawals are usually not taxed.

The account you choose depends on several factors, including whether you need a tax break now or in the future.

If you anticipate being in a lower income tax bracket when you start your withdrawals, a Traditional IRA might be the better choice. Not only will you owe less income tax per year you contribute, but you could also be taxed at a lower rate when taking distributions.

However, a Roth IRA might be better if you expect to reach a higher tax bracket when taking distributions. You might be paying more upfront, but your withdrawals will be tax-free regardless of your future income tax bracket.

When structuring or restructuring your investments, choose a mix of tax-advantaged and taxable accounts. This will enable you to minimize your tax liability. Not only that, but if you reinvest any earnings, like dividends or capital gains, they can compound upon themselves and continue to grow at an expedited rate.

Strategies for Achieving Tax Efficiency

Every investor has their own specific goals they want to meet, as well as their preferred timeline. While there’s no one right way to achieve tax efficiency, here are a few tried-and-true methods.

Hold Investments for the Long Term

Most types of assets used for investment or personal purposes — including stocks, bonds and real estate property — are considered capital assets. When you sell one of them, they’ll be subject to either a capital gain or capital loss.

A realized capital gain occurs when you sell an investment for more than its original purchase price. A capital loss is when you sell an asset for less than its original value or purchase price.

Capital gains fall into two categories:

• Short-term: These are assets held less than 1 year.
• Long-term: These are assets held more than 1 year.

Assets held less than a year (short-term gains) are taxed at the ordinary income tax rate, which may be higher than the long-term capital gains rate. In other words, holding your investments for the long-term could mean a more favorable tax rate.

Use Tax-Advantaged Accounts

Using tax-advantaged accounts is another way to achieve tax efficiency. Here are a few options:

• Traditional IRAs: With this, you can defer taxes on your earnings — whether they’re dividends or capital gains. You’ll pay taxes when you start taking distributions (after age 59 ½).
• Roth IRAs: Your account contributions have already been taxed, meaning you don’t have to worry about getting taxed again when it comes time to withdraw (also after age 59 ½).
• Traditional 401(k)s: Just like with a Traditional IRA, you contribute pre-tax dollars to a 401(k) plan. When you start taking distributions, the IRS will take your withdrawals. A major benefit of having a 401(k) is that many come with employer-matching contributions.
• Roth 401(k)s: Some employers offer Roth 401(k) plans. Contributions are made with after-tax dollars and grow tax-free. Withdrawals are also tax-free.

Invest In Tax-Efficient Funds

Another option is to invest in tax-efficient funds, like:

• Tax-efficient mutual funds: Investors who are in a higher tax bracket could benefit from a tax-efficient mutual fund. These accounts may produce a lower rate of returns, but they’re also designed to offset any capital gains and losses. They also prioritize long-term gains over short-term ones.
• Index funds: Index funds, like mutual funds and exchange-traded funds (ETFs), are designed to replicate the actual stock market returns. They’re also naturally tax-efficient as they minimize the need for frequent trading of securities.
• ETFs: As a type of index fund, ETFs are also tax-efficient. Whenever you sell your shares, the transaction goes through another buyer rather than the fund company. This reduces the risk of capital gains and lowers your taxes.
• Municipal bonds: Both municipal (muni bonds) and corporate bonds are tax-exempt at the federal level, making them a tax-efficient choice.

Implement Tax-Loss Harvesting

Tax-loss harvesting is when you offset any capital gains with capital losses. This can reduce your tax liability for the year. It can also minimize short-term capital gains, which preserves your investment portfolio.

Say you sold an asset that incurred a capital gain. By implementing tax-loss harvesting, you can sell another asset for a loss and use that to offset the gain. This can potentially result in some major tax savings.

But what if your capital losses are higher than your capital gains? In that case, you can legally deduct up to $3,000 of your total net loss from your income taxes for the year. Any amount higher than this limit gets carried over to future years.

Use a Health Savings Account (HSA)

Contributing to an HSA can also help with tax efficiency. That’s because these accounts are triple-taxed:

• HSA contributions aren’t taxed at the federal level.
• HSA contributions aren’t subject to FICA taxes (that is, Medicare and Social Security taxes).
• Contributions may grow tax-free until withdrawn, but withdrawals for qualified medical expenses aren’t taxed.

Example of Tax-Efficient Portfolios

When it comes to creating a tax-efficient portfolio, asset allocation matters. Generally speaking, investors should take advantage of both tax-advantaged and taxable accounts. That way, they can balance the risks and rewards of investing, while keeping their overall tax liability low.

Here’s an idea of what a tax-efficient portfolio might include:

• Taxable accounts: This could include index funds or other accounts that hold securities like stocks and bonds that earn interest or dividends. It could also include assets like real estate with realized capital gains.
• Tax-exempt accounts: Some types of accounts, including Roth IRAs and Roth 401(k)s, are funded with after-tax dollars. This means you’ll pay taxes on that year’s income, but any withdrawals are tax-free. Certain accounts, like HSAs, are fully tax-exempt provided they’re used for qualifying expenses.
• Tax-deferred accounts: Traditional IRAs and 401(k) plans are taxed on a deferred basis. This means you get a tax break upfront, but must pay taxes on any distributions.

As an investor, you could theoretically have an index fund, traditional 401(k), Roth IRA and HSA all at the same time. Each comes with its own tax benefits, as well as potential drawbacks and limitations.

Potential Drawbacks and Considerations

Everything, including tax efficiency, comes with its potential drawbacks. Before incorporating it into your investment strategy, here are a few considerations:

• Returns on taxable accounts, like brokerage accounts, may be subject to capital gains tax (when an asset is sold).
• Tax-advantaged accounts, like IRAs or 401(k)s, typically have contribution limits and other restrictions.
• Short-term capital gains are usually taxed at your ordinary income tax rate (which may be high).
• Contributions to tax-deferred accounts grow tax-free and can lower the current year’s tax liability, but you’ll have to pay taxes on future withdrawals.
• Contributions to tax-exempt accounts also grow tax-free, and withdrawals aren’t taxed, but you won’t get a tax break for the years you contribute money.
• When it comes to tax efficiency, not all accounts are equal; some are more efficient than others.
• Some tax-efficient investments, like mutual funds, may have a lower rate of return than other investments.

Tax efficiency requires careful management and consideration. It’s also important to understand the tax consequences of different types of accounts before adding any to your portfolio. When in doubt, consult a tax professional or financial advisor about your options.

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