Strategies for individuals to save taxes on their investments
Tax written on a wooden cube in front of a laptop
There are numerous strategies available to investors in order to help manage, defer and reduce taxes that you pay on your investment income. A financial advisor can work with you to understand the tax implications of the investments you hold and offer personalized strategies for you; some examples may be 401(k), IRA or health savings accounts.
Tax-saving investing should be a part of every investor’s strategy; it can increase after-tax returns.
Tax-deferred accounts
Tax-deferred accounts give investors an effective way to save on taxes by postponing your payment until withdrawal. This type of account is especially advantageous for retirement savers, however, when choosing one it’s important to think about your personal investment horizon and tax rate now and in the future.
When used correctly, tax deferral has the potential to compound over time — meaning previous earnings are generating more earnings and boosting returns in what is known as “the eighth wonder of the world.”
The longer you hold onto these types of investments, the more significant this benefit becomes. That’s why it’s often beneficial to put those that have lower taxes burdens into taxable accounts while those with higher benefits should go into tax advantaged ones.
Accounts such as IRAs, SEP IRAs, SIMPLE IRAs and annuities can defer taxes on various assets like mutual funds, exchange-traded funds (ETFs) and bonds. Many employers also match contributions made into these accounts which can significantly supercharge savings. Look at each of these account types when deciding how much money will go where.
Tax-advantaged accounts
A tax-efficient portfolio strategy will not only lower your overall tax bill but also require less money up front in order to meet your investment goals. And because this type of investing will put more dollars back into your pocket — or reinvested — it can cause some serious long-term growth through compounding interest. Tax-efficient investing involves using accounts and vehicles specifically designed to minimize taxes.
Depending on your situation, tax-advantaged accounts like 401(k), health savings accounts (HSAs) and Coverdell Education Savings Accounts may lower the taxes you owe. Each of these allow you to save income before it’s taxed and then withdraw it without paying taxes — as long as it goes towards approved expenses.
Picking investments
While tax efficiency is an important factor when selecting your investments, it should not be the only focus. Instead invest in assets that meet your diversification, liquidity and investment goals at a risk level you feel comfortable with.
Tax-loss harvesting
Tax-loss harvesting is the selling of investments that have lost value in order to offset capital gains from other assets, a strategy that can reduce current and future tax bills for investors in higher brackets. However, this technique may not be useful for everyone if used inside retirement accounts where gains could be taxed differently than ordinary income.
The prices you paid for individual securities over time must be tracked in order to optimize this strategy with cost basis tracking. To get an accurate calculation of your tax loss you will need all correct numbers; for instance, average out purchases or track them individually over time.
Although the idea of harvesting losses might sound attractive, only do so if it lines up with your overall investment strategy. Rebalancing your portfolio frequently on top of reviewing underperforming positions around year-end may give better sense to the use of strategies like tax-loss harvesting.
Portfolio planning
When it comes to retirement or planning to retire, the right financial plan can help you save money. Depending on your lifestyle and goals, tax-efficient savings options like 529 college saving plans or traditional IRAs may offer tax advantages. Tax-advantaged investments like municipal bonds that are generally exempt from federal income taxes and any applicable state taxes could also be a way for you to save.
At the same time, where each investment resides and how they’re stored also has an impact on your taxes. Your advisor can help design asset location strategies based on your tax situation.
Tax-efficient investing is a crucial component of any long-term investment strategy — even small changes to your tax bill could increase after-tax returns over time and contribute to wealth-building. While tax rules and rates change over time, the importance of factoring them into decision-making remains constant: Consider including strategies like tax loss harvesting in asset management plans, as well as options that come with inherent tax efficiency.
