Taxes are an unfortunate side effect of successful investing. You can set up a tax efficient investing strategy to help lower those taxes over time. More importantly, it will leave more money in your pocket to reinvest, compound and grow.
A tax efficient investment strategy is nothing new. It’s been used by the wealthy since tax codes were enacted. It’s legal and you don’t need a high-priced CPA to put an effective strategy together. If you know the current tax rates, you are half way there. After that you just need to know how to use the tax code in your favor. In order to do that we need to start with the basics.
What Is Tax Efficient Investing?
Like costs, taxes eat into your investment gains. Which puts a limit on how your money grows. But thanks to our overly complex tax system, you have ways to reduce, suspend or eliminate them.
The basic tax efficient investing strategy should lower your tax liability based on your financial goals both now and in the future. When done right, it should maximize your after tax dollars. Which is the ultimate goal.
You’ll have to take the tax consequences into account when making any investment decision. In order to do this, you’ll need to know a few things:
- The current tax code
- The right asset allocation to use
- The types of accounts to use
- The time to hold each investment
The tax code will decide how you use the different accounts, investments, and allocation when building your tax efficient strategy.
Know The Tax Code
The biggest obstacle to any tax efficient investing strategy is a constantly changing tax code. Until a flat tax is installed (which will never happen), you will deal with tax rate changes. And trying to figure out the future tax rates decades from now is impossible. Focus on your financial goals and how the current rates affect them. You can make adjustments when things change.
Income, interest, dividends and capital gains are all taxable. Interest is considered income and is taxed at the same rates. Dividends and capital gains are usually taxed at different rates.
Capital gains tax is divided between short-term (one year or less) and long-term (more than one year) capital gains. Short term capital gains are taxed at the same rate as your income. Long term capital gains are given favorable tax treatment.
When the tax code favors one stream over another, you should adjust your asset allocation to take advantage of the difference.
Tax Efficient Investments
You will only get so far knowing the tax code. The real success comes from your asset allocation and taking advantage of tax efficient investments. This becomes more important as your income tax rates rise.
This is where tax-free bonds are used. Municipal bonds and to a lesser degree U.S. Treasuries fall into this category. Municipal bonds are exempt from federal income tax. Which can have a big impact on your after tax income. U.S. Treasuries are only exempt from state and local income tax and only benefit those investors in high income tax states.
How much you benefit from this will depend on your income tax rates. When choosing a municipal bond or bond fund, first compare its tax equivalent yield to corporate bonds. If the risks are the same, choose the higher yielding bond. Even if it happens to be the corporate bond. Remember, your goal is to maximize your after tax dollars. Not just to reduce your taxes.
When using tax efficient investments it is important to be aware of the type of account you use.
Taxable Or Tax Advantaged Accounts
Imagine how hard saving for retirement would be if you were taxed every year on that savings. It’s not a pretty picture. That’s the reason retirement accounts are important. But that advantage comes with a price. Which gives bank and brokerage accounts a place in your tax efficient investing strategy too.
The biggest advantage of taxable accounts is the easy access to funds. It’s also the biggest downfall. Since investments must be sold before you can get access to the money, you are quickly hit with capital gains.
With that in mind, investments in taxable accounts should be more long-term focused. That means holding each investment for at least one year to avoid short-term capital gains. In addition, municipal bonds and other tax efficient investments are perfect for taxable accounts. The point here is to save the short-term investing and trading for your retirement accounts.
Tax Advantaged Accounts
Your 401k, 403b, pension, traditional IRA and Roth IRA fall under tax advantaged accounts. All but the Roth IRA offers tax-deductible contributions and allows you to grow your money tax-free until its withdrawn at retirement. At that point it’s taxed as income, where you might be in a lower tax bracket.
Alternatively, the Roth IRA takes after tax contributions and allows your money to grow and be withdrawn tax-free. The hope being that you are in a higher tax bracket.
Which tax advantaged account you choose will depend on your income and qualifications. A Roth IRA has income limits and at a certain point loses it’s luster to the tax-deductible accounts as your income tax rate climbs.
Either way, you get the best tax efficient return on your investments taking full advantage of these accounts. Just keep in mind that penalties and age restrictions limit when you can take money out.
Taxes are no different from investment costs like transaction fees. It eats into your returns, limiting your ability to grow your money. A good tax efficient investing strategy will allow you to avoid the higher costs of taxes. Remember, it’s a balancing act between lower taxes and higher after tax dollars.
Don’t let tax reduction alone steer you away from money-making opportunities. What matters most is how much you keep after taxes. You are doing things right if you can maximize your after tax dollars.