When I started investing, I thought the best way to get rich was to pick hot individual stocks and buy low and sell high as often as possible.
Compounding interest and tax-efficient investing was for suckers and old ladies. There were three problems with this way of thinking.
One, you have to know which stocks are hot before they get hot. Two, you have to know when the stock is low to buy.
And three, you have to know when the stock is high to sell.
Without all three of these pieces of information, you will lose money. And if you do it as often as possible, you will lose money rapidly.
Meanwhile, compounding is arguably the strongest force in the universe, and nothing is more certain than death and taxes. Taking advantage of the former and minimizing the latter is truly the path to riches.
While merits of compounding interest are rightfully lauded, its nerdy brother, tax-efficiency is unjustly overlooked.
But tax-efficient investing is smart investing and one of the few methods guaranteeing greater returns.
Why Tax-Efficient Investing Is Important
How would you feel if your investment returns were reduced up to 30% every year? Depending on your tax bracket and if you make money each year in the form of taxable interest income, dividends, or capital gains, by not being tax-efficient, it’s exactly what will happen.
Uncle Sam sees all those gains from your investments as income. And if it’s income, he wants his cut. We also know the more you make, the more he wants.
Compounding interest may be a powerful force, but it’s only as powerful as your rate of return.
If that rate of return is sapped year after year or if you start with less to invest because it’s taxed, the less you’ll have to compound.
But there is a way out. The government has a very powerful tool to make people do things they don’t normally do – tax breaks.
They want you to save for your retirement. They want you to buy bonds so they don’t have to raise taxes. Or they want you to save for college to have an educated citizenry.
There are two distinct methods of tax-efficient investing: Tax-advantaged accounts and tax-efficient investments within taxable accounts.
Each has its advantages, disadvantages, and degree of tax-efficiency.
Investing In Tax-Advantaged Accounts
This is the easy way to take advantage of the government tax breaks because essentially everything that goes in or comes out will save you on your tax bill.
However, most have penalties for taking the money out early.
If it has a three-digit number chances are it’s one of these. These three-digit numbers and associated letters refer to a section of the U.S. tax code.
How do these accounts save you on your tax returns?
It depends on the type of account it is, but there are three ways: Tax-exemption, tax-deferral, and tax-free growth.
Each of these accounts takes advantage of one or more of these methods.
In tax-exempt accounts, when you sell your investments to start spending the money, you don’t have to pay taxes on the money you normally would in a taxable account.
Depending on your tax bracket, this could be a sizable chunk of the investment.
These are your Roth IRAs, Roth 401ks (retirement plans), and 529 Plans (education). The strategy is you fund the account with money that’s already been taxed (e.g. money sitting in your bank account from your paycheck) with the promise you won’t owe taxes on future growth.
These accounts are advantageous if you’re currently in a lower income bracket than you will be in the future.
It’s because you paid a smaller percent in taxes on the money going into these accounts than you would have on the money coming out.
The more money you can pump into these accounts from others, the more untaxed income you’ll have in the future.
You should take advantage of any Roth 401k matching from your workplace and possible 529 Plan state tax deductions.
One last tip is to do Roth conversions in your life when you don’t have a lot of income. This could be during a time of unemployment or even early retirement.
Though you will pay ordinary income tax on the amount you convert, you’ll be in a lower income tax bracket; it won’t be as high as other times in your life.
With tax-deferred accounts, you get a tax break up-front but will owe taxes on the entire distribution as income when you withdraw your money (unlike with tax-exempt accounts where you pay all your taxes up-front).
It might not seem like a good deal, but keep in mind that by getting a tax-exemption on the funds you put into these accounts, you could have significantly more money invested that will grow over time.
These are your traditional 401ks, traditional IRAs, and other retirement savings plans.
The way the tax-deferral works is usually with your 401k, your employer deducts your contribution to your 401k account before calculating your taxes on your paycheck (which effectively makes it non-taxed funds).
With an IRA, you write them a check or transfer the money from your bank account and you get to deduct that amount from your taxable income when you file your taxes.
It has the same effect as what your employer would have done with 401k contributions.
Contrary to the Roth account advantage of being in a lower federal income tax bracket, with tax-deferred accounts, it’s more advantageous if you’re currently in a higher income tax bracket.
It’s because you will avoid paying a higher percentage of your money in taxes now than in the future.
While you’re taxed on any matching contributions you receive in this account when you withdraw, it’s still money you wouldn’t have had otherwise.
Even if you contribute to a Roth 401k at work, the matching funds will go into a traditional 401k account.
Probably the least talked-about and least well-understood tax optimization method is tax-free growth. It’s because all tax-advantaged accounts take advantage of this trait, but a word about why it’s important.
In your tax-advantaged accounts, you will have some growth in the form of dividends, interest, or even capital gains if you sell some of your investments that increased in value.
Normally each of these avenues of investment income is taxed either at income tax rates or capital gains rates.
Because they’re in your tax-exempt or tax-deferred accounts, these taxes don’t apply and will give you more money you can invest and grow.
Health Savings Accounts
Most tax-advantaged accounts take advantage of two of the three listed methods of tax-efficiency, the HSA (Health Savings Accounts) takes advantage of all three.
HSAs are a special type of savings account. You can use the funds to buy investments like mutual funds or ETFs, and the account can grow.
It’s unlike FSAs (Flexible Spending Accounts) where your balance sits there as cash. The HSA proceeds, however, have to be spent on medical expenses.
You can fund your HSA with pre-tax money, it will grow tax-free, and if you use the funds for qualified medical expenses, the money you spend is tax-exempt.
However, there are a plethora of rules you have to follow, which brings us to another important point.
Some Restrictions Apply
Tax benefits are nice, but if you don’t follow the rules, not only will you owe the taxes you avoided, but you’ll incur a penalty.
The big rule with the retirement accounts is you have to wait until a certain age to begin withdrawing. With accounts like HSAs and 529 Plans, the funds have to go for specific purposes.
Break any of these rules and you will pay taxes on the money used early and a 10% penalty on the gains.
However, you will only owe taxes and the 10% penalty on the gains for Roth and 529 accounts because you already paid taxes on the contributions.
The reason for this is because you agreed to use the money for a specific purpose the government was directing you to.
Break that agreement and the IRS will want their money back and then some.
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Tax-Efficient Investing within Taxable Accounts
Outside of tax-advantaged accounts, you have some control over your tax liability in taxable accounts (such as brokerage accounts).
While these methods don’t have a significant impact on your tax burden, every bit counts. Every nickel you don’t fork over to the government is a nickel that can potentially grow.
Long-Term vs. Short-Term Capital Gains Tax
When you sell an investment that has appreciated, you have a capital gain. That gain can be taxed. How much depends on how long you kept the investment before selling it.
If you owned the investment for a year or less, the gains made on the investment will be taxed as regular income.
Concerning investments owned longer than a year, you’re taxed a lower, long-term capital gains rate determined by your income bracket.
If you’re thinking of selling that stock you bought 364 days ago, wait a day or two (or three if it’s a leap year) to save money.
Speaking of capital gains, a strategy you can use to reduce taxes on your capital gains distributions is to harvest your losses.
What does that mean?
Let’s say you have two stocks you bought a few months ago in your investment account. One you love and its value skyrocketed; time to sell.
The other you want to kick to the curb because it’s worth half of what you bought it for and is only looking bleaker.
After you sell both, the IRS lets you offset the gains from one with the losses of the other. You will only owe taxes on the difference.
If you still have losses greater than your gains, up to a certain amount, you can use those losses to offset your other income or future gains.
So, while it’s not fun to have losses, at least you can use them to reduce your tax burden.
Dividends are payments made by the companies of the stocks you own from their earnings. Think of it as a “thank you” for being a stock-holder.
However, these payments are taxable. Dividends are taxed as regular income unless they are qualified dividends.
Qualified dividends are taxed at the lower, long-term capital gains tax rate. Keep this in mind if your investing strategy involves using dividends as a source of income.
Bonds are a loan. In the case of Treasury bills, Municipal bonds, and Series-I (U.S. savings bonds), they’re loans to the local and federal governments.
Interest on these bonds is state and local tax-free. In the case of municipal bonds, they’re tax-free at the federal level.
Tip: If you want to own either corporate bonds or investments paying ordinary dividends, consider putting them in a tax-advantaged account.
A vital part of tax-efficient investing is to diversify your tax burden. You don’t have a crystal ball so it’s better to be prepared for all situations.
You don’t know how tax laws are going to change.
Will our national debt precipitate a massive tax hike for everyone? Can the U.S. go to a flat tax system? Who knows.
You don’t know what your situation will be like in the future. Will you be in a higher or lower tax bracket? Are you going to work until you are 95 or will you retire when you’re 40?
It’s best to be prepared for any contingency.Tweet This
It’s a good idea not to solely concentrate on a single method of tax-efficiency in your investing. Utilize all the above strategies so you will have multiple sources of income to optimize your tax burden.
For example, if you have both Roth and Traditional retirement accounts, withdraw only enough money from your traditional account to take you to the edge of the next tax bracket.
Then tap into your Roth account (or even liquid savings) that can’t be taxed to keep your effective tax rate low.
Final Word On Tax-Efficient Investing
A tax-efficient portfolio and investing strategy are paramount to maximizing your returns both in the short-term and the long-run. You can pick all the best stocks, minimize your fees, and avoid expenses.
But if you’re not minimizing the impact of taxes on your investments, it’s all for naught. It may seem like a boring task, but it’s the boring ones with the biggest impact.