Financial management

It pays to be in a tax-efficient portfolio

12 minute read
  •  
February 15, 2022

When it comes to investing, there are many things you can control like your asset allocation, your reaction to market volatility, and the fees and taxes you pay.

To try to keep their costs down, many investors choose broadly diversified funds with low fees. But did you know that if you don't manage your portfolio with tax efficiency in mind, taxes could take a bigger bite out of your investment returns than average fund fees? For example, investing in active funds with an average expense ratio of 1.07% in a nonretirement account can trigger taxable events that could potentially cost you about 2% of your returns in taxes every year.* By simply repositioning these assets in a tax-efficient way, you can eliminate your annual tax liability on these investments.

Here’s the good news. Your advisor builds tax-efficient strategies—like asset location—directly into your financial plan to help minimize your tax burden. And they revisit them regularly as your goals and needs change.

6 strategies we use to lower your investment taxes

Pick tax-efficient funds

When choosing investments for your nonretirement accounts, your advisor will recommend products like index mutual funds and ETFs (exchange-traded funds) that come with built-in tax advantages.

Because passive investments track a benchmark, they generally trade less frequently than active funds. This trading structure helps to limit the amount of capital gains distributions that get passed down to you in the form of a taxable event. ETFs are settled in a way that allows them to potentially avoid triggering capital gains altogether. With their low costs and tax benefits, they make a great foundation for taxable portfolios.

Your advisor also considers whether municipal bond funds are right for you. They tend to pay lower interest rates than their taxable counterparts but offer income generally free from federal taxes.** The higher your tax bracket, the more attractive the tax-equivalent yield becomes, making them a good option for high-income investors.

Depending on your goals, risk tolerance, and time horizon, your advisor may recommend a portion of active funds for the opportunity to outperform a benchmark. They’ll also work with you to figure out the best place to hold these funds, which brings us to strategy 2.

Hold your investments in the right types of accounts

Your advisor builds tactics for tax-efficient asset location into your custom financial plan to help you reduce, defer, or even eliminate taxes on your investment gains.

At the highest level, dividing your assets in the following way can help to minimize your tax liability:

  • Hold investments that aren't tax-efficient (such as actively managed mutual funds and taxable bonds) in retirement accounts where you can defer taxes.
  • Hold tax-efficient investments (such as index funds, ETFs, and tax-exempt bonds) in taxable accounts.

For example, say an investor has $100,000 and invests:

  • 50% in stocks, divided equally across their IRA and taxable accounts.
  • 50% in taxable bonds, divided equally across their IRA and taxable accounts.

While this may seem like a balanced approach to some investors, it doesn’t factor in taxable events within the nonretirement accounts and the impact those events could have on after-tax returns.


By simply repositioning assets on a $100,000 account, you could potentially save hundreds of dollars in taxes each year. This type of investment change, which takes minutes to make, could really help your savings add up over time.


More good news ... your advisor reviews your accounts and makes recommendations to keep taxes low on income interest, dividends, and capital gains.

In the above example, they’d recommend putting 100% of your taxable bonds and the majority of dividend stocks in your IRA to help defer the annual taxes you'd otherwise owe.

When helping to decide if a portion of actively managed funds make sense for your taxable accounts, your advisor considers your long-term strategy. If your plan is to buy and hold the funds, you won’t need to worry about generating your own realized gains until you start taking withdrawals in the future. But keep in mind that you’ll still be responsible for any capital gains that occur within the fund itself—from trades made by the fund manager as they attempt to outperform the benchmark. These trades trigger a taxable event for you, even if your fund is currently worth less than you paid for it.

Your advisor is here to help you weigh these important considerations and avoid purchases right before a scheduled distribution that could result in an unexpected taxable event. Depending on your individual situation, they’ll also help determine what combination of tax-deferred and tax-exempt retirement options make the most sense for you. This is an important topic that considers the taxes you’ll pay now versus later.

Identify tax-loss harvesting opportunities

Your advisor can help you better understand how to identify and use losses to keep your portfolio tax-efficient. This is especially useful when markets are volatile because it’s about using investment losses to help lower your tax bill.

Here’s how it works. As an investor, you're only taxed on net capital gains—the amount you earn minus any investment losses. 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. This intentional selling of investments at a loss to lower your tax bill is known as tax-loss harvesting.

For example, you could sell fund shares at a loss and use the proceeds to buy another fund that maintains your asset allocation. Now, let’s say you have a year when your capital losses are greater than your capital gains. If you realized a $10,000 gain on one investment but had a $14,000 loss on another, your net loss would be $4,000. In addition to writing off $10,000 of your realized losses against your $10,000 in gains, you can also use up to $3,000 of your net losses a year to offset ordinary income on your federal income taxes. In this instance, you could claim the $3,000 loss on your tax return and carry forward the remaining $1,000 to future years.

Use a tax-efficient cost basis method

When you sell shares, for spending or rebalancing purposes, it’s important to make tax-efficient decisions while keeping your asset allocation in check.

Vanguard Personal Advisor Services® uses a cost basis method called “MinTax,” which seeks to minimize the tax bite of rebalances, as well as any personal distributions made from your portfolio.

Here’s how it works. Let’s say you need to withdraw $3,000 from your taxable account. We’ll help you accomplish this by seeking to sell specific shares with the highest acquisition costs first (resulting in a lower tax bill), while keeping you aligned to your target allocation.

Best of all, you don’t need to manually review all your transactions (initial purchases, subsequent purchases, reinvestments, etc.) to save more and pay less. MinTax has built-in capabilities that do the work for you.

Take tax-efficient withdrawals to maximize retirement income

When it's time for retirement withdrawals, it’s important to take them from your account in a tax-efficient order.

A common strategy that works for many investors is to start by taking your required minimum distribution (RMD) from your retirement accounts, if applicable. Then move on to your taxable accounts, keeping in mind that you want to pay taxes when you think they'll be lowest. If you expect your future tax rate to be higher, consider withdrawing from your tax-deferred traditional IRA and 401(k) accounts next, followed by your tax-free Roth accounts. Conversely, if you expect your future tax rate to be lower, consider withdrawing from your tax-free accounts before your tax-deferred accounts.

Other factors like how to tax-efficiently pass assets to your heirs can also impact your withdrawal order. Your advisor is here to discuss your circumstances and can help determine if a more tailored approach makes sense for you.

Make the most of your giving

Your advisor can also help you give in a tax-efficient way. Consider these strategies to make the most of your charitable giving:

  • Itemize cash donations on your tax return to take advantage of deductions, up to certain limits.
  • Gift appreciated securities, such as mutual funds, ETFs, or individual stocks, to minimize future capital gains. You may want to donate through a donor-advised fund since not all charities can accept donations of investments.
  • Donate up to $100,000 annually from your IRA directly to a qualified charity through a qualified charitable distribution (QCD). As long as you meet the requirements—you're at least 70½ when making the gift, and the check is made payable directly to the charity—the distribution is excluded from your taxable income. In addition, your QCD will count toward your RMD for that year.
  • Give the gift of education. Since contributions to 529 education plans are considered gifts, you can contribute up to $16,000 per year for single filers ($32,000 if married filing jointly) per beneficiary without triggering federal gift tax.

We’re always focused on optimizing your portfolio’s returns. These are just a few of the strategies your advisor uses to help control your taxes now and in the future.

Thanks for belonging to the Personal Advisor community.

*Morningstar data as of December 14, 2021. Over the last decade, 400 actively managed U.S. stock funds with a 10-year track record had an average expense ratio of 1.07% with an annual estimated after-tax cost (in the form of dividends and capital gains distributions) of 2.08%.

**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 consult a tax advisor before taking action. Vanguard does not provide legal or tax advice.

 

All investing is subject to risk, including the possible loss of the money you invest. 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. We recommend you consult a tax and/or legal advisor about your individual situation.

When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.

Advice services are provided by Vanguard Advisers, Inc., a registered investment advisor, or by Vanguard National Trust Company, a federally chartered, limited-purpose trust company.