Tax-Efficient Investing

Tax-Efficient Investing

          Now that we understand how taxes impact investments, let’s look at how investors may benefit from and incorporate tax-efficient investing into their strategies. Why should anyone care? Whether you want to save for retirement or generate income, tax-efficient investing may help you reduce your tax burden while increasing your bottom line. Some of the ways that will be discussed to manage, postpone, and reduce federal income taxes include investment product selection, the timing of buy and sell decisions, account selection, and taking advantage of realized losses.

Ways To Be Tax-Efficient

Tax-Advantage Accounts

          There are two types of accounts: taxable accounts and tax-advantaged accounts. Taxable investment accounts allow you to purchase and sell securities such as stocks, bonds, exchange-traded funds (ETFs), and index funds but will be taxed when you sell, based on how long you hold the assets. 

In comparison, consider tax-advantaged retirement accounts such as a 401(k) or an individual retirement account (IRA). These accounts protect your assets from taxes while you’re building the account. Contributions to these accounts are made before tax.  Income taxes are levied withdrawals made in retirement. Here is our blog that goes more in-depth about IRAs!

There’s also the Roth IRA, which investors make contributions to with after-tax money, but then retirement withdrawals are made tax-free. 

Figure One: % Difference In Future Value

Traditional vs. Roth

         Let’s say an investor is trying to be tax-efficient by first picking an IRA that best suits their needs. The first factor to consider is the individual’s tax bracket when making contributions versus when taking withdrawals. In the case of the image above (Figure One), the bottom left (Dark Blue Cells) of the table show the higher after-tax value because the individual anticipates withdrawals will be made when they are in the same or a lower tax bracket as when they made the contributions.

This can also be observed in Figure Two, where the Traditional IRA outperformed the Roth IRA because the individual expected their withdrawals to be taxed at a lower rate.

Figure Two: High Contribution Tax Rate & Low Retirement Tax Rate

Roth vs. Traditional

         Let’s look at the same scenario (Figure One) but from a different perspective. This time, the top right (Light Blue Cells) of the table show higher after-tax value because the individual anticipates withdrawing funds in a higher tax bracket than when they initially contributed. 

This can also be observed in Figure Three, where the Roth IRA outperformed the Traditional IRA because the individual expected their withdrawals to be taxed at a higher tax rate.

Figure Three: Low Contribution Tax Rate & High Retirement Tax Rate

Tax-Efficient Investments

         Some investments are more tax-efficient than others by design. Tax-managed funds and exchange-traded funds (ETFs), for example, are more tax-efficient than stock funds since they generate fewer capital gains. Actively managed funds, on the other hand, purchase and sell shares more often, potentially generating greater capital gains (and more taxes for you).

Another example is bonds. Municipal bonds are very tax-efficient since the interest income is not taxable at the federal level and is often tax-free at the state and municipal levels as well. Because of this, Munis are frequently referred to be triple-free. Since they are already tax efficient, these bonds are ideal for taxable accounts.

The table below is a general summary of where tax-efficient assets and tax-inefficient assets should be placed in either taxable or tax-advantaged accounts.

Taxable Accounts (Brokerage Account)

Tax-Advantage Accounts (401k, IRAs, 403B, 539)

Stocks that are held for more than a year

Stocks that are held for one year or less

Low-turnover stock funds, ETFs, or Index Funds

Actively managed funds with high turnover/generate short-term gains

Qualified Dividend Stocks & Mutual Funds

Inflation Protected Bonds & Zero-Coupon Bonds

Municipal Bonds & Series I Bonds

Corporate Bonds

What To Consider

          On paper, it seems like tax-efficient investing shouldn’t be difficult, but it does need some preparation and planning. There are a few components to consider.

  1. With IRAs being tax-deferred, one should take full advantage by putting tax-inefficient investments into these accounts.
  2. Don’t let the tax tail wag the dog. It implies that many individuals utilize particular financial or tax techniques, such as making an irrevocable gift or even delaying selling an investment because they don’t want to pay taxes. Sure, there are some instances when adopting specific actions might benefit you financially and bring the additional advantage of tax savings. But it shouldn’t be the primary motivation. There are more essential things going on with your money. The tail shouldn’t be wagging the dog. The dog (your overall financial strategy) should be wagging its tail.
  3. When in doubt, always contact a professional investment planner, financial advisor, or tax expert who can assist you in determining the best tax approach for your position and goals.
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All investors are unique.  The above characteristics are examples, but may not reflect your particular investor demographics or situation.  An advisor with Edgar Investment Management, LLC will assist you with finding the best type of account for you. 

Investment advisory services are offered through Edgar Investment Management, LLC, an investment advisor registered with the State of Texas. Edgar Investment Management, LLC only offers investment advisory services where it is appropriately registered or exempt from registration and only after clients have entered into an investment advisory agreement confirming the terms of engagement and have been provided a copy of the firm’s ADV Part 2A brochure document.

The content found on this website is developed from sources we believe provide accurate information and is for educational purposes only. The information on this website is not intended as tax or legal advice. Everyone’s tax and legal situation is different, so please consult trusted and knowledgeable legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided on this website are for general information, and should not be considered a solicitation for the purchase or sale of any security.

Material and information found on this website is not intended as an offer or solicitation for the sale or purchase of any specific security, mutual fund, ETF, bond, or investment strategy.  

Investing is risky!  No guarantee as to performance of any investment is implied by this website.  Make sure you have evaluated your options and spoken with trained professionals before you implement any investment strategy.  Past performance is not indicative of future results.  

Please be advised that Edgar Investment Management, LLC is a financial advisory firm specializing in investment management and financial planning services. We do not offer or provide any CPA-related services, including tax preparation, tax planning, or other accounting services. If you require assistance with tax-related matters, we recommend consulting a qualified CPA or tax professional who can provide specialized advice tailored to your individual needs.

Edgar Investment Management, LLC is not a Public Accounting firm.

 

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