The Importance of Tax-Efficient Investing
- We'll discuss actionable strategies to help you manage your taxable return.
- Tax-smart investors hold tax-efficient investments in taxable accounts and less tax-efficient investments in tax-advantaged accounts.
When it comes to income, you know that it's not what you make, but what you keep after taxes that really counts. And these days, with higher capital gain taxes and the 3.8% Medicare investment income surtax (that affects certain filing status thresholds1), being mindful of investment taxes is more important than ever.
Return lost to taxes
The Schwab Center for Financial Research has examined the long-term impact of expenses and taxes on investment returns and concluded that, while asset allocation and investment selection are still some of the most important factors affecting returns, minimizing costs and taxes isn't very far behind.
Because mutual funds may distribute capital gains throughout the year, mutual fund investors are often concerned about losing investment returns to taxes. But individual stock and bond investors are vulnerable to taxes as well, depending on how they manage their investments.
As disconcerting as a return lost to taxes might be, the good news is you can exercise a good deal of control here. Consider this: Diversification and asset allocation are great tools for helping to reduce portfolio volatility, but we're still going to be subjected to the short-term whims of the market, no matter how diligent we might be in setting up our portfolios and selecting our individual investments. Where we have the greatest degree of control is the area of expenses and tax-efficient implementation. It makes sense, then, to bring tax-efficiency near the forefront of our investment plan.
How do I try to maximize tax efficiency?
Broadly speaking, investments that tend to lose less of their return to income taxes are good candidates for taxable accounts. Likewise, investments that lose more of their return to taxes could go in tax-advantaged accounts. Here’s where you might consider placing your investments:
Tax-advantaged accounts such as Roth IRAs and tax-deferred accounts including traditional IRAs, 401(k)s and deferred annuities.
Individual stocks you plan to hold more than one year
Individual stocks you plan to hold one year or less
Tax-managed stock funds, index funds, exchange-traded funds (ETFs), low-turnover stock funds
Actively managed funds that may generate significant short-term capital gains
Stocks or mutual funds that pay qualified dividends
Taxable bond funds, zero-coupon bonds, inflation-protected bonds or high-yield bond funds
Municipal bonds, I Bonds (savings bonds)
Real estate investment trusts (REITs)
Of course, this presumes that you hold investments in both types of accounts. If all your investment money is in your 401(k) or IRA, then just focus on asset allocation and investment selection.
In general, holding tax-efficient investments in taxable accounts and less tax-efficient investments in tax-advantaged accounts should add value over time. However, there are other factors to consider, including:
- Periodically rebalancing your portfolio to maintain your strategic asset allocation will cause additional tax drag on returns in your taxable accounts. This is because, typically, rebalancing involves selling assets that have grown beyond your original allocation and buying assets that have fallen below your original allocation – in other words, taking profits from your winners and buying assets that have underperformed. And in taking profits from assets that have grown, you may incur either long- or short-term capital gains. To minimize the chances of this, you may want to focus your rebalancing efforts on your tax-advantaged accounts and include your taxable accounts only when necessary. Keep in mind, adding new money to underweighted asset classes is also a tax-efficient way to help keep your portfolio allocation in balance.
- Active trading by individuals or by mutual funds, when successful, tends to be less tax-efficient and better suited for tax-advantaged accounts. A caveat: Realized losses in your tax-advantaged accounts can't be used to offset realized gains on your tax return.
- A preference for liquidity might prompt you to hold bonds in taxable accounts, even if it makes more sense from a tax perspective to hold them in tax-advantaged accounts. In other situations, it may be impractical to implement all of your portfolio's fixed income allocation using taxable bonds in tax-advantaged accounts. If so, compare the after-tax return on taxable bonds to the tax-exempt return on municipal bonds to see which makes the most sense on an after-tax basis.
- Estate planning issues and philanthropic intent might play a role in your portfolio planning. If you're thinking about leaving stocks to your heirs, stocks in taxable accounts are generally preferable. That's because the cost basis is calculated based on the market value of the stocks at the time of death (rather than at the time they were originally acquired, when they may have been worth substantially less). In contrast, stocks in tax-deferred accounts don't receive this treatment, since distributions are taxed as ordinary income anyway. Additionally, highly appreciated stocks held in taxable accounts for more than a year might be well-suited for charitable giving because you'll get a bigger deduction, and the charity gets a bigger donation, than if you liquidate the stock and pay long-term capital gains tax before donating the proceeds.
- The Roth IRA might be an exception to the general rules of thumb discussed above. Since qualified distributions are tax free, assets you believe will have the greatest potential for higher return are best placed inside a Roth IRA, when possible.
The bottom line
You have a lot of control when it comes to maximizing your after-tax wealth. First, decide on a suitable asset allocation. Next, select low-cost investments that make sense for you. Then, be tax-smart about where you hold your investments.
1. The 3.8% Medicare investment income surtax applies to the following filing thresholds: single filers with incomes of $200,000 or greater; taxpayers who are married and filing jointly or qualifying widow(er)s with incomes of $250,000 or greater; and taxpayers who are married filing separately with incomes of $125,000 or greater.
Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.
Investing in REITs may pose additional risks such as real estate industry risk, interest rate risk and liquidity risk.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.
Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third-parties and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, or legal, tax, or investment advice, or a legal opinion. Individuals should contact their own professional tax advisors or other professionals to help answer questions about specific situations or needs prior to taking any action based upon this information.
Any examples are hypothetical and provided for informational purposes only and not intended to represent a recommended investment strategy for any specific investor.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.