Maximize Your Net Return with Tax Efficient Investing

By Jane Young, CFP, EA

Taxes should not drive your investment strategy but minimizing taxes can increase your net return.   Investment decisions should be driven by your goals, financial situation, time horizon and risk tolerance.   However, with a little planning, you can also build a tax efficient portfolio.  The Schwab Center for Financial Research conducted a study on the long-term impact of taxes and other expenses on investment returns.  They found the most important factors impacting returns are investment selection and asset allocation but that minimizing taxes and other costs were not far behind.  

For tax purposes your investment accounts fall into three major categories, tax free, tax deferred and taxable.  In tax free accounts, primarily Roth accounts, you invest after tax dollars and you do not owe taxes as your money grows or when it is withdrawn.  Tax deferred accounts are traditional IRAs and company retirement plans where your contribution is deducted from your income, and you pay taxes upon distribution.  There are also restrictions on when you can take distributions.  A taxable account is funded with after tax money, and you pay taxes when dividends and capital gains are incurred.

Match investments with the right account type.   Think of your portfolio as a whole rather than striving to balance each account individually.  For example, your entire Roth IRA may be invested in the stock market because it is expected to earn the highest long -term return and you do not pay taxes on the gain.  You can balance this with fixed income investments in a taxable or tax deferred account.

Taxable accounts generally contain cash and short-term bonds to cover your liquidity needs.  However, for long-term, consider low turn-over mutual funds, exchange traded funds and individual stocks for your taxable account.   Generally, index funds will have lower turn-over and are more tax efficient than managed funds.  If you have a high income, consider tax-free municipal bonds for your taxable account.

Managed mutual funds, high turn-over funds, dividend paying investments and bond funds are well suited for traditional retirement accounts such as 401k plans.

There are several additional strategies you can use to minimize tax in a taxable account.  Avoid paying short term capital gains by waiting at least a year before selling securities at a gain.  Utilize tax loss harvesting, by selling poor performing securities at a loss to offset gains.  Avoid selling a large amount of appreciated assets in a given year.  Spread the sale over multiple years to avoid getting bumped into a higher bracket.  Consider gifting highly appreciated stock to a charity, your children, or grandchildren.   Qualified charities pay no income tax, and your children are probably in a low tax bracket.

Whenever possible, maximize contributions to your retirement plans.  If you are saving for college utilize a 529 plan to save on state tax and avoid tax on appreciation.  If you have a high deductible health insurance plan contribute to a tax-deductible Health Savings Plan.