Taxes are everywhere, every day, to such an extent that one might let that all-important, mid-April deadline for filing your annual tax returns sneak up on you. One problem with waiting until the last minute: by that point, it may be too late to implement an efficient investment strategy for minimizing your tax bill.
Returns lost to taxes
For investors, it's not just how much you make that matters—it's how much you keep after taxes. Like investment selection and asset allocation, the amount lost to taxes and other costs is a key factor affecting your returns. Even small amounts can add up over the years, so anything you can do to reduce the drag will help in the long run.
The good news is you can exercise some control here. With a bit of planning, you can make your portfolio more tax-efficient and hold on to a greater share of your returns.
How do I maximize tax efficiency?
A big part of tax efficiency is putting the right investment in the right account.
Investment accounts can be divided into two main categories:
- Taxable accounts, such as brokerage accounts, are good candidates for investments that tend to lose less of their returns to taxes.
- Tax-advantaged accounts, such as an IRA, 401(k), or Roth IRA, are generally a better home for investments that lose more of their returns to taxes.
What does that mean in practical terms? Here we've matched some common kinds of investments with taxable or tax-advantaged accounts:
|Individual stocks you plan to hold for 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||Real estate investment trusts|
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 picking appropriate investments and allocating to them according to your goals, risk tolerance and timeframe.
Diversifying by tax treatment
Holding your investments in the most tax-appropriate type of account can complement your savings plans by helping to reduce taxes (or, in the case of a Roth, eliminate entirely the taxes on investment returns).1 Spreading your investments across accounts with different tax treatments can also give you more flexibility in managing your taxes when you start drawing from your savings in retirement. Call it "tax diversification."
Diversifying by tax treatment can be especially important if you're uncertain about the tax bracket you'll end up in in retirement. For example, by investing in a taxable brokerage account and then splitting your retirement-savings contributions between a tax-deferred IRA or 401(k) and an after-tax Roth account, you would have more options for managing your income in retirement, regardless of your tax bracket.
So, if your goal is to minimize your overall tax burden, you could focus on taking tax-free municipal bond income, qualified dividends, and long-term capital gains (which currently tend to be taxed at lower rates) from your taxable accounts and tax-free income from your Roth accounts. Then you could take only enough money from your taxable IRA or 401(k) to cover your spending needs or satisfy required minimum distributions, if applicable.
Of course, this is just one approach. Some investors may prefer to rely on their taxable and tax-deferred accounts (along with Social Security and pensions) for income and allow their tax-free Roth savings to continue growing for as long as possible.
Estate planning, charitable giving considerations
Making strategic use of your different accounts according to their tax treatment can also help you formulate your charitable giving and estate planning goals—different accounts receive different types of gift and estate tax treatment. For example, you might want to give appreciated securities from your taxable accounts to charity for a full fair market value deduction and no capital gains tax.
You can also leave such shares to your heirs, who will receive a step-up in cost basis after you're gone (more on that below). Roth IRAs also make a great bequest, as distributions are free from income tax for your beneficiaries.
No matter how you decide to split up your portfolio between account types, remember that for asset allocation purposes, you should still think of all your investments as being part of a single portfolio. Here's a simplified illustration:
If you kept all your stocks in your taxable account and an equal amount of money in bonds in your tax-advantaged account, that would not constitute two portfolios, one 100% stocks and the other 100% bonds. You would actually have one portfolio consisting of 50% stocks and 50% bonds. The different assets just happen to be in different accounts.
Other tax-related investment considerations
In general, holding tax-efficient investments in taxable accounts and less tax-efficient investments in tax-advantaged accounts should have potential to add value over time. However, there are other factors to consider, including:
- Periodically rebalancing your portfolio to maintain your target asset allocation. Rebalancing involves selling and buying assets that have either grown beyond or fallen below your original allocation. When you take profits from your winners and buy assets that have underperformed, it could cause an additional tax drag on returns in your taxable accounts.
You may also incur either long- or short-term capital gains when you take profits from assets that have grown. You may want to focus your rebalancing efforts on your tax-advantaged accounts and include your taxable accounts only when necessary. 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, if 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 through a process known as "tax loss harvesting."
- A preference for income 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. The charity also 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. Because 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.
Keep more of your money with tax-efficient investments
If you want to keep more of your returns, managing your investments with tax efficiency in mind is a must. What's more, tax efficient investing techniques are accessible to almost everyone—it just takes some planning to reap the potential benefits.
1If you take a distribution of Roth IRA earnings before you reach age 59½ or before the account is five years old, the earnings may be subject to taxes and penalties.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone.
Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.
This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
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. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.
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, rebalancing, and asset allocation strategies do not ensure a profit and cannot protect against losses in a declining market.
Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events can be created that may affect your tax liability.
Neither the tax-loss harvesting strategy, nor any discussion herein is intended as tax advice, and does not represent that any particular tax consequences will be obtained. Tax-loss harvesting involves certain risks including unintended tax implications. Investors should consult with their tax advisors and refer to Internal Revenue Service ("IRS") website at www.irs.gov about the consequences of tax-loss harvesting.
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