Rising bar graph of blue cylinders with last one red on blue background, abstract modern minimal success, growth, progress or achievement concept.

Keep more of what you earn through tax-efficient investing

7 minute read
March 28, 2024
Taxes on investments

"Beware of little expenses; a small leak will sink a great ship."

—Benjamin Franklin, Poor Richard’s Almanack

The notoriously thrifty Ben Franklin understood the great erosion that results from a slow drip of assets. Perhaps that's why he famously bemoaned the certainty of taxes, which to be frank, may not be quite immovable a force as the founding father implied.

That is, a tax bill may be an inevitability, but investors can delay or control that bill, which can lead to better investor outcomes.

There is little doubt that taxes are one of the largest costs faced by many investors today. Other investment-related fees—asset-weighted average expense ratios, for example—have fallen substantially in past decades.

And the potential for investors to benefit from cost savings is significant. We ran an analysis on the outcome of a hypothetical $100,000 investment with a 6% reinvested return at different cost levels. Whether those costs stem from transaction fees, advice, or Uncle Sam's cut, the inevitable outcome is clear. Higher costs crimp a portfolio's growth unless there is additional value derived from paying those costs.

A penny saved on fees is a penny that keeps compounding

Notes: The portfolio balances shown are hypothetical and do not reflect any particular investment. In this example, the accounts return 6% annually, then investment costs are taken at the end of the year. The rate of return is not guaranteed. The final account balances do not reflect any taxes or penalties that might be due upon distribution. Costs are one factor that can impact returns. There may be differences between products that must be considered prior to investing.

Source: Vanguard calculations.

That cost-cut triumph can be a boon for investors who seek out low-cost investments. And yet, investment fees are just one side of the cost coin. The flip side—taxes—can take an even bigger bite from returns.

The good news is that tax costs can be controlled in many instances. Investors just need to know how.

Investment tax efficiency: hierarchy of opportunity

Take advantage of tax-advantaged accounts. For many investors, the low-hanging tax fruit is their 401(k), IRA, or other tax-advantaged retirement plan. In terms of order, Vanguard recommends a retirement plan first, if one is available, up to the amount that captures the employer match. What should come after that is not always clear-cut but a combination of tax-deferred and after-tax (e.g., Roth) accounts can offer flexibility when accounting for an investor's time horizon, expected future tax rate, and income flexibility needs in retirement (to offset Social Security and Medicare tax cliffs, for example).

Outside of retirement planning, certain health savings accounts (HSAs) and education savings plans (e.g., 529s) can also offer attractive tax advantages worth considering.

Control tax costs through trading and asset placement strategies. Tax-aware investors can strategically hold or sell from a brokerage account to lower capital gains tax or harvest losses for a later offset. Attractive yet tax-inefficient investments—like an actively managed mutual fund with higher turnover—can be held inside a tax-advantaged account, so dividend or short-term capital gains payouts can remain sheltered. In short, a little investor education on tax treatment can go a long way toward generating better after-tax portfolio returns.

Reduce tax penalties. Retirement savers may be unaware of the full impact of an early withdrawal, the taxable event one may create, or the potential penalty. Advice is often the key link that can help an investor make tax-efficient, cost-conscious decisions—even during a time of need—that can increase the likelihood of keeping long-term goals on track.

The stakes are high

Taxes may be one of two certainties in life, but investors don't have to pay more than their due.

With the help of advisors, tax professionals, and client-centric education, investor tax bills could be meaningfully minimized. More widespread use of holistic, tax-aware planning strategies, and better tax-related communications, disclosures, and educational efforts could go a long way toward getting investors closer to their financial goals.

At the end of the day, it's not how much investors earn that defines success. It's how much they keep.

Explore more investing strategies

Related links:

Vanguard's principles for investing success (research, issued November 2023)

Flipping the script on how we talk about investing success (article, issued December 2023)

Prep for the new year with these five simple tax tips (article, issued December 2023)

Greater tax efficiency through equity asset location (research summary, issued October 2023)

Most Viewed

Ready to invest? See how to open an account
Start with this step-by-step guide to opening a personal investment account, such as a general investing brokerage account or an IRA.
Backdoor Roth IRA What it is and how to set it up
If you are a high-income earner, a Backdoor Roth IRA may be a good retirement investment option for you. Learn what it is and how to set up this type of retirement plan.
Who owns Vanguard?
Who owns Vanguard? Learn why we're proud to be the only investor-owned investment management company and how we focus on putting investor needs first.
Are bonds a good investment right now?
Learn how high-quality bonds can play a valuable role in your portfolio in a high-yield environment.
Top 6 tips: Your year-end financial checklist
Discover our new international fund

Neither Vanguard nor its financial advisors provide tax and/or legal advice. This information is general and educational in nature and should not be considered tax and/or legal advice.

Any tax-related information discussed herein is based on tax laws, regulations, judicial opinions, and other guidance that are complex and subject to change. Additional tax rules not discussed herein may also be applicable to your situation. Vanguard makes no warranties regarding such information, or the results obtained by its use, and disclaims any liability arising out of your use of, or any tax positions taken in reliance on, such information. We recommend you consult a tax and/or legal advisor about your individual situation.