What You Need To Know About Tax-Efficient Investing For Beginners

Reduce Your Tax Liability And Maximize Your Net Income.

Every investment has costs. Taxes can sting the most out of all the expenses and take the greatest bite out of your returns. The good news is that tax-efficient investing can reduce your tax liability and boost your bottom line, whether you’re saving for retirement or generating cash.

What You Need To Know

• Taxes can be one of the highest expenses and take the biggest bite out of the earnings on your assets.
• The importance of tax-efficient investing increases as your tax band rises.
• Tax-efficient investments should be made in taxable accounts.
• Tax-inefficient investments are better suited in tax-deferred or tax-exempt accounts.
• Tax-advantaged accounts like IRAs and 401(k)s have yearly contribution limits.

Why Is Tax-Efficient Investing So Essential?

The Schwab Center for Financial Research analyzed the influence of taxes and other costs on investment returns over the long term. Investment selection and asset allocation are the primary determinants of returns.

The study discovered that lowering your tax burden had a considerable impact. There are two reasons for this:

• You lose the tax money you pay.
• You forfeit the growth that the funds could have created had they remained invested.

Your post-tax returns are more significant than your pre-tax returns. It’s those after-tax dollars, after all, that you’ll be spending now and in retirement. Tax-efficient investment is essential if you wish to optimize your returns and retain more of your capital.

Investing Account Types

Tax-efficient investing entails selecting the appropriate investments and accounts to store them. Two primary types of investment accounts exist:

• Taxable assets
• Tax-favored accounts

There are pros and downsides to each form of account. Both account types are crucial aspects of establishing an investment strategy.

Taxable Accounts

A brokerage account is an example of a taxable account. These accounts have no tax advantages. Tax-advantaged funds such as individual retirement accounts (IRAs) and 401(k)s have fewer limits and more flexibility. With a brokerage account, unlike an IRA or 401(k), you can withdraw your funds at any time, for any reason, and without tax or penalty.

How you are taxed on the returns from these accounts depends on how long you have kept an asset before selling it. Depending on your tax bracket, if you maintain investments in the account for more than a year, you will pay the more favorable long-term capital gains rate: 0%, 15%, or 20%. If you hold an investment for one year or less, short-term capital gains will apply. This is the same as your usual income tax bracket. 2

Tax-Deferred Accounts

Generally, tax-advantaged accounts are either tax-deferred or tax-free. Tax-deferred accounts, such as traditional IRAs and 401(k)s, offer an immediate tax deduction. You may be eligible to deduct your donations to these programs, which gives an immediate tax benefit. The tax is deferred until the money is withdrawn in retirement, which is when it is paid.

Different rules apply to tax-exempt accounts, including Roth IRAs and Roth 401(k)s. These contributions are made with after-tax monies, so you do not enjoy the same upfront tax deduction as with typical IRAs and 401(k)s. Yet, the growth of your savings is tax-free, and eligible withdrawals during retirement are also tax-free. For this reason, these accounts are exempt from taxation.54

The restrictions on when and how money can be withdrawn from these accounts are the trade-off for their tax advantages. If you are under the age of retirement when you make withdrawals, you will typically be required to pay taxes and/or penalties.

Tax-Effective Investing Techniques

IRAs and 401(k)s are tax-advantaged accounts with yearly contribution restrictions. In 2022, you can contribute a total of $6,000 to your IRAs, or $7,000 if you are 50 years of age or older (thanks to a $1,000 catch-up contribution). 6 The regular contribution ceiling will climb to $6,500 in 2023. The catch-up maximum remains at $1,000, so those 50 or older can contribute a total of $7,500. 7

With 401(k)s, you can contribute up to $20,500 in 2022 or $27,000 with the catch-up contribution. In 2022, the combined employee and employer contribution cannot exceed $61,000. The catch-up contribution increases this amount to $67,500. 8

You can contribute up to $22,500 in 2023 or up to $30,000 with the catch-up contribution. The total employee and employer contribution for 2023 cannot exceed $66,000. This rises to $73,500 with the addition of the catch-up contribution. 9

It would be ideal if you could hold all of your investments in tax-advantaged accounts, such as IRAs and 401(k)s, due to the tax advantages. Because to the annual contribution restrictions and lack of flexibility (withdrawals that are not qualified are subject to taxes and penalties), this is impractical for all investors.

The best strategy to enhance tax efficiency is to place investments in the appropriate account. In general, tax-efficient investments are preferable for taxable accounts. Conversely, investments that tend to lose more of their returns to taxes are attractive candidates for tax-advantaged accounts.

Tax-Efficient Investing

Most investors are aware that capital gains may be subject to taxation upon the sale of an investment. Nonetheless, you may be liable if your investment pays out capital gains or dividends regardless of whether you sell it or not.

Certain investments are naturally more tax-efficient than others. For example, among stock funds, tax-managed funds and exchange-traded funds (ETFs) are often more tax-efficient since they generate fewer capital gains. Actively managed funds, on the other hand, tend to purchase and sell securities more often, so they may earn greater capital gains dividends (and more taxes for you).

Bonds are another illustration. The interest income from municipal bonds is not taxed at the federal level and is frequently exempt at the state and local levels as well. Munis are frequently dubbed triple-free because of this. These bonds are excellent options for taxable accounts due to their tax efficiency.

Treasury bonds and Series I bonds (savings bonds) are also tax-efficient because they’re free from state and local income taxes. Yet, corporate bonds lack tax-free provisions and, as a result, perform better in tax-advantaged accounts.

Many investors keep both taxable and tax-advantaged accounts so they can enjoy the benefits each account type offers. Obviously, if all of your investment funds are in a single account type, you must prioritize investment selection and asset allocation.

The Conclusion

One of the fundamental concepts of investing (whether for retirement savings or cash generation) is to minimize taxes. An effective technique to minimize taxes is to hold tax-efficient investments in taxable accounts and less tax-efficient investments in tax-advantaged accounts. That should provide your accounts the best opportunity to expand over time.

Even if it is preferable to keep an investment in a tax-advantaged account, there may be times when tax considerations must take a back seat to other considerations. For example, a corporate bond may be more suitable for an IRA, but you may choose to store it in your brokerage account to maintain liquidity. Yet because tax-advantaged accounts have stringent contribution limits, you may be required to maintain certain investments in taxable accounts, even if they would be more advantageous in your IRA or 401(k).

Consult with a skilled investment planner, financial counselor, or tax expert who can assist you in determining the optimal tax approach for your situation and objectives.