6 tax-saving strategies for smart investors
Everyone wants to pay less taxes, right?
We’re all investing to meet specific goals. What we want to achieve varies from one investor to another, but we can likely all agree we want more of our returns going toward our goals—and less to the IRS.
Not sure where to start? Consider these questions:
- Which investments should I choose?
- Where should I hold my investments?
- When should I sell shares?
- How can I make the most of my charitable giving?
- What order should I withdraw my investments in?
Here are 6 of my favorite strategies for lowering investment taxes.
1. Consider tax‑efficient funds
In picking investments for your portfolio, there are many factors to think about. When it comes to your nonretirement accounts, 2 crucial considerations are investment return and tax efficiency.
One important goal may be to maximize after-tax returns for your portfolio. Choosing investments with built-in tax efficiencies, such as index funds—including certain mutual funds and ETFs (exchange-traded funds)—is one way you can minimize returns lost to taxes.
ETFs may offer an additional tax advantage. The way transactions are settled allows the ETF to potentially avoid triggering capital gains.
Because ETFs offer the best of both worlds—low costs and tax efficiency—I often use them as a foundation for some clients’ portfolios.
Note: Index mutual funds track a benchmark, so their goal is to match the benchmark’s performance. If you’re looking to outperform a benchmark, these investments may not be what you’re looking for.
2. Weigh using actively managed funds focused on tax efficiency
Some clients I work with want an active managed approach to their investments but don't want the tax burden that can come along with that approach. When I build those clients' portfolios, I might choose funds from Vanguard's tax-managed investments. They offer active management with a focus on tax efficiency.*
For those clients in higher tax brackets, we may consider investing in tax-exempt bond funds, which pay lower interest rates but maximize after-tax returns.**
When I work with my clients, I build tactics for tax-efficient asset location into their custom financial plan, so they’re able to keep more of their returns.
3. Divide assets among accounts
Picking tax‑efficient investments is one method to maximize after-tax returns, but you also want to choose the right types of accounts to hold your investments.
At the highest level, asset location is a way to minimize taxes by dividing your assets among taxable and nontaxable accounts. So you put investments that aren’t tax‑efficient in accounts where you can defer taxes, and you hold tax‑efficient investments in taxable accounts.
When I work with my clients, I build tactics for tax‑efficient asset location into their custom financial plan, so they’re able to keep more of their returns.
Taking advantage of tax‑efficient asset location
Asset location is a way to minimize taxes by dividing your assets among different types of accounts. Here’s what that could look like:
Taxable accounts should hold tax‑efficient assets like:
- Index mutual funds
- Index ETFs
- Tax-exempt bonds
Nontaxable accounts should hold less tax‑efficient assets like:
- Actively managed mutual funds
- Taxable bonds
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4. Look for opportunities to offset gains
As an investor, you’re only taxed on net capital gains—the amount you gained minus any investment losses—so any realized losses can help lower your tax bill. Therefore, if you know you’re going to have realized gains, it may make sense to look for opportunities to realize losses to offset them.
For example, if you have shares of funds or stocks that have lost value since you purchased them, you may want to consider selling them.
This intentional selling of investments at a loss to lower taxes is known as tax-loss harvesting.***
If you have a year when your capital losses are greater than your capital gains, you can use up to $3,000 of net losses a year to offset ordinary income on your federal income taxes. You can also “carry forward” losses to future tax years. As with any tax-related topic, tax-loss harvesting has rules and restrictions, such as the wash sale rule, you should be aware of before using this method.
5. Optimize your withdrawal order
When you start taking money out of your portfolio, make sure your withdrawal strategy factors in taxes.
Once you start drawing down from your nonretirement accounts, think about taking all income produced from the investments (dividends, interest, and capital gains) and paying out to the money market, rather than reinvesting it, so you don’t end up paying taxes twice. If you reinvest the income produced and then sell the shares for a gain, you’ll owe taxes on the income produced and capital gains taxes on the appreciation. A strategy like this is one way I make sure my clients keep as much money in their pockets as possible.
Depending on your legacy goals, this order may vary.
6. Make the most of your giving
If philanthropy is part of your “money purpose,” you can give in a way that can help lower your taxes.
Consider these strategies to make the most of your giving:
- Itemize cash donations on your return to take advantage of tax deductions, up to certain limits.
- Gift appreciated securities, such as mutual funds, ETFs, or individual stocks, to minimize future capital gains. (Not all charities can accept donations of investments, so I often advise my clients to donate through a donor-advised fund, which makes it easy.) Learn more about donor-advised funds.
- Donate up to $100,000 annually from your IRA directly to a qualified charity through a qualified charitable distribution. (As long as certain rules are met-such as you’re at least 70½ when making the gift, and the check is payable directly to the qualified charity-then the distribution shouldn't be taxable income.)
*It is possible that the funds will not meet their objective of being tax‑efficient.
**Although the income from municipal bonds held by a fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal alternative minimum tax.
***Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could have higher costs than the original investment and could introduce portfolio tracking error into your accounts. There may also be unintended tax implications. We recommend that you carefully review the terms of the consent and consult a tax advisor before taking action.
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