Tax Efficient Investment Strategies Improve Total Return


Depending on your tax bracket and the type of gains realized, the IRS can chew up to 43.8% of it in taxes.

Simply put, tax efficiency is a measure of how much of an investment’s return is left over after taxes are paid. Tax efficiency shouldn’t become so much of the focus that it degrades your portfolio performance; rather it should help preserve gains as much as possible. With the help of a professional financial advisor, you should be able to build a portfolio to meet your financial goals, while keeping tax efficiency in mind.

The first building block in tax efficiency is determining if your investment accounts are taxable, tax deferred or tax exempt. Typically, retirement accounts are tax deferred. The next piece is understanding the difference between how short-term and long-term gains are taxed. Short-term gains (sale of investments held less than one year) can be taxed up to 43%, while long-term gains (sale of investments held more than one year) are normally taxed at a lower 20% rate.

For investors who want to keep more of their earnings and stay out of a higher tax bracket, investment choices that offer the lowest tax burdens, relative to their interest or dividend income, are critical. Sharp investors will hold tax-efficient investments in their taxable accounts and allocate those with higher tax implications to tax deferred accounts.

Taking a long-term, buy-and-hold approach to investing is an effective way to reduce the portfolio gains lost to taxes. Limiting trading will help minimize tax liability, but it isn’t a panacea. You also need to consider the different types of investments that offer a lower tax impact.

Exchange traded funds (ETFs); instead of actively managed mutual funds is another effective strategy. ETFs passively track a basket of assets, like an index fund. Many mutual funds generate taxable gains to investors throughout the life of the investment. Even those mutual fund investors, who buy and hold, can lose up to two percentage points in returns as a result of taxes on capital gains.

In addition, investors should make sure that their financial advisors are offsetting portfolio gains with losses, when possible. In certain situations, it may be beneficial to sell, take the loss and use the proceeds to invest in a comparable stock or fund. Taxpayers are able to use capital losses to offset up to $3,000 ordinary income each year.

Due to the complexities of investing and U.S. tax laws, even savvy investors can’t always effectively manage their portfolio to minimize their tax burden. It’s important to have your financial advisor and tax preparer work together. Decisions about tax-efficient investing can mean the difference between achieving or falling short of your financial goals.