Tax-Efficient Investing: Guide and How to Do It
Making strategic investment decisions can help minimize your tax burden, keeping more money to invest and grow.
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No one enjoys handing money over to the IRS, but everyone is responsible for paying taxes. Taking advantage of tax-efficient investing options can help you reap the benefits of certain tax breaks, especially if you fall into a higher tax bracket.
What is the most tax-efficient way to invest money?
The most tax-efficient way to invest money depends on your personal financial situation but generally includes using tax-advantaged accounts to house investments that may generate a lot of taxable income or taxable gains, and using non-tax-advantaged accounts to house investments that don’t generate much taxable income or taxable gains.
Tax-advantaged accounts such as 401(k)s, IRAs, 529s, health savings accounts and irrevocable trusts can be a better place to house investments that may generate a lot of taxable income or taxable gains.
Taxable brokerage accounts may be a better place to put less actively traded or more tax-efficient investments.
If tackling investing while weighing the tax consequences makes your head spin, or you want a second opinion to ensure you’re maximizing tax benefits, consulting a financial advisor can help. They can assess your situation and show you how to enhance the tax efficiency of your investments.
Here’s how to use these accounts and investments to minimize your tax bill.
A tax-advantaged account is an account that receives special tax benefits such as tax deductions for contributing to the account, deferral of the capital gains tax or income tax generated by investments in the account, or even tax-free withdrawals. By eliminating or deferring taxes on investments that are inside tax-deferred accounts, the account owner can keep more of their money and build wealth faster.
401(k)s
A 401(k) is an employer-sponsored account into which employees contribute a portion of their paycheck to save for retirement. Money that employees contribute to the account isn’t taxable. The employee decides how to invest the money in the account, and the capital gains or dividends on those investments aren't taxable until the employee withdraws the funds in retirement. Also, employers may match some or all of the employee’s contributions, which is free money to the employee.
Traditional IRAs
Traditional individual retirement accounts provide tax-deferred growth.
Contributions are tax-deductible.
Earnings are tax-deferred, which means you will be responsible for paying income taxes on distributions in the future.
Roth IRAs
A Roth IRA is an individual retirement account to which you contribute after-tax money, which then grows and can be withdrawn in retirement tax-free.
Roth 401(k)s
Roth 401(k)s are workplace-sponsored retirement accounts into which employees contribute after-tax dollars. There’s no immediate tax deduction, But the earnings in the account grow tax-free; withdrawals are tax-free, too.
529s
A 529 plan is a savings plan that provides tax-free investment growth and withdrawals for qualified education expenses. There is no federal tax deduction for 529 contributions, but many states offer tax benefits for residents. Earnings grow tax-free, and withdrawals are tax-free when used for qualified expenses.
Health savings accounts (HSAs)
People with high-deductible health insurance plans can contribute to health savings accounts. An HSA provides triple tax advantages:
Contributions are tax-deductible.
The money in the account grows tax-deferred.
Withdrawals are tax-free when used for qualified medical expenses.
Irrevocable trusts
Removing assets from your personal estate by setting up an irrevocable trust can reduce your estate taxes and gift taxes. For example, a grantor retained annuity trust (GRAT) is an irrevocable trust into which the trust creator (the grantor) puts assets and then receives an annuity from the trust. The rest of the assets go to the grantor's beneficiaries. Because the trust is irrevocable, the assets no longer belong to the grantor in the eyes of the IRS, which can reduce the grantor’s future estate taxes.
» Dive Deeper:
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on NerdWallet Wealth Partners' site. For informational purposes only. NerdWallet Wealth Partners does not provide tax or legal advice.
Types of tax-efficient securities
Some investments are more tax-efficient than others, regardless of what type of account they’re in.
Mutual funds vs. index funds and exchange-traded funds
Mutual funds offer access to a diversified mix of securities, such as stocks, bonds or both, through one investment vehicle. However, some mutual funds are less tax-efficient than others.
Actively managed mutual funds can generate taxable capital gains that pass through to the investor. (Some actively managed mutual funds are managed to reduce investors’ tax liabilities, but the added tax benefits often come with higher fees.)
Passively managed mutual funds, such as index funds, often mimic an underlying benchmark index and are generally more tax-efficient than active mutual funds. This is because index funds usually buy and hold their positions and thus generate fewer taxable capital gains.
Exchange-traded funds (ETFs) also offer access to a broad selection of securities in one investment. Similar to index mutual funds, most ETFs simulate a benchmark index, but ETFs are structured differently from mutual funds, making them more tax-efficient. ETFs only incur capital gains taxes when you sell the investment. The investor decides when to sell their ETF positions, making it easier to avoid short-term capital gains tax rates.
» Which is right for you? ETFs vs. index funds
Municipal bonds
Interest on municipal bonds is generally exempt from federal taxes, and purchasing tax-free munis in the state in which you reside can also provide state and local tax breaks. It can make sense to hold municipal bonds in taxable brokerage accounts.
Treasury bonds
Interest on Treasury bonds is generally not subject to state and local taxes. However, you may owe federal income taxes on the interest, and the interest earned is taxed at ordinary income tax rates rather than at long-term capital gains rates (which are lower).
Real estate
Investing in real estate is popular as you can take advantage of tax deductions and write-offs, favorable capital gains tax treatment and potentially some other incentives.
Life insurance
Proceeds from life insurance, both permanent and term, are usually tax-free. Permanent life insurance policies accumulate cash value while deferring taxes, and policyholders can borrow up to the cost basis, or the sum of the premiums paid in, of their life insurance policy without being subject to tax.
Annuities
As investment products sold by insurance companies, annuities benefit from tax-deferred growth until distributions begin.
The more you earn, the more complex your taxes become. Learn the 10 traps to dodge.
on NerdWallet Wealth Partners' site. For informational purposes only. NerdWallet Wealth Partners does not provide tax or legal advice.
Other tax-efficient investing strategies
Beyond asset location and investment selection, you can use other strategies in an effort to pare back your tax burden.
Managing long-term and short-term capital gains
Pay attention to the length of time you hold an investment and the size of that gain. The capital gains tax rate you pay is determined in part by the length of time you owned the investment.
Short-term capital gains tax rates generally apply when selling an investment held for one year or less. The rates are the same as the ordinary income tax rates and range as high as 37%.
Long-term capital gains tax rates generally apply to investments held longer than a year. The rates are 0%, 15% or 20%, depending on your filing status and income level. If you can wait to get past that one-year mark before selling investments with capital gains, you’ll likely pay a lower tax rate.
Tax-loss harvesting
If you sold some of your investments at a loss, those losses could offset some of your other taxable capital gains. Tax-loss harvesting can be an effective way to reduce your tax bill, but there are rules, such as avoiding wash sales (when you sell a security to take a loss and then buy the same, or a very similar, security back within 30 days).
As mutual fund managers trade, trim and add to various positions, the fund can generate capital gains and income distributions. Sometimes the fund will have enough losses to offset the gains, but any outstanding gains must be distributed to and are taxable for shareholders. Mutual fund companies publish estimates of capital gain distributions toward the end of the year. If these capital gains distributions are significant, you can consider selling your shares of that fund and buying another mutual fund or ETF before the distribution hits.
Cash donations
Cash donated to charity can reduce your taxable income, but gifting highly appreciated marketable securities, real estate or private business interest can provide even greater tax advantages. This is because those highly appreciated securities may generate large taxable capital gains if you sell them instead. By gifting these assets in lieu of cash donations, you get the tax deduction and avoid capital gains taxes.
Qualified charitable distributions
Retirees with traditional IRAs must eventually take required minimum distributions (RMDs) from their accounts and pay taxes on those withdrawals. These RMDs also might move an investor into a higher tax bracket.
Individuals who don’t need these distributions to cover daily living expenses and don’t want the additional taxes can take advantage of qualified charitable deductions. QCDs allow you to give your RMDs directly to charity (up to $100,000 each year), and reduce your taxable income by the gifted amoun.
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