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Tax-efficient investments

Tax-efficient investments
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Tax-efficient investing is about making the most of your money by keeping more of what you earn. When you invest in a taxable account, the taxes you pay on your returns can affect your long-term results. By choosing tax-efficient investments and other tax-saving strategies, you can help manage your tax burden and keep your portfolio working toward your goals.

Tax-efficient investing is especially important for investors in higher tax brackets or those with significant assets in taxable accounts. That's why smart tax planning is a key part of building wealth and helping you reach your financial goals.

Key insights

  • Tax-efficient strategies can help reduce capital gains taxes and boost your after-tax returns.
  • ETFs and index funds are naturally tax-efficient because they tend to sell assets less frequently, resulting in fewer taxable gains for investors.
  • Those in higher tax brackets may be the investors most likely to benefit from tax-managed or tax-exempt funds.

What is tax-efficient investing?

Tax-efficient investing means choosing investments and strategies that help you keep more of your returns after taxes. This approach focuses on minimizing the taxes you owe on payments you receive from investments in your taxable accounts, like dividends , interest, and capital gains distributions . It also includes using tax-advantaged accounts like IRAs, 401(k) plans, and 529s to defer or eliminate taxes on your investment earnings. By being thoughtful about what you invest in and where you hold those investments, you can help your money grow more efficiently.

Why is tax-efficient investing important?

Taxes can take a bite out of your investment returns, especially if you're in a higher tax bracket or live in a high-tax state. Over time, even small differences in after-tax returns can have a noticeable effect on your wealth. Tax-efficient investing helps you keep more of what you earn, so your money can work harder toward your goals.

Types of tax-efficient investments

There are several types of tax-saving investments and strategies you can consider for your portfolio. Finding the right combination depends on your goals, tax bracket, state of residence, and where you hold your investments.

Exchange-traded funds (ETFs)

ETFs are naturally tax-efficient because of how they handle redemptions. Unlike mutual funds, which may generate taxable gains for shareholders by selling securities when other investors cash out, ETFs use a process called in-kind redemption that eliminates the need to sell. This allows ETFs to minimize taxable capital gains distributions until investors choose to sell their shares.

Index mutual funds

Index mutual funds are passively managed, meaning they buy and sell securities less frequently than actively managed mutual funds. This lower turnover often results in fewer taxable capital gains distributions to investors. However, when shareholders redeem their shares, index mutual funds often sell securities, which can create taxable gains for remaining investors. Despite this, index mutual funds are still usually more tax-efficient than actively managed funds.

Tax-managed stock funds

Tax-managed stock funds are designed to reduce the taxes you pay on your investment returns. These funds use strategies like offsetting gains with losses (similar to tax-loss harvesting), holding stocks for longer periods to avoid short-term gains, and minimizing taxable payments to investors (such as dividends and capital gains distributions). Though these funds are typically more expensive than comparable funds without the tax management layer, they might be worth considering if you want to focus on lowering taxes while still investing in stocks.

Municipal bonds & bond funds

Municipal bonds are issued by state and local governments to fund public projects, like schools, roads, and water systems. The interest you earn from most municipal bonds is exempt from federal income tax, and in some cases, state and local taxes as well. Municipal bond funds offer a convenient way to invest in a diversified pool of these bonds.

While municipal bonds and bond funds typically produce lower yields than taxable bonds, the tax savings can make them attractive for investors in higher tax brackets.

U.S. Treasury securities

U.S. Treasury securities—like Treasury bills, notes, and bonds—are issued by the federal government and considered one of the safest investments. While the interest they earn is subject to federal income tax, it's exempt from state and local income taxes. This can make Treasury securities particularly attractive if you live in a high-tax state.

Are tax-exempt investments right for you?

Tax-exempt investments, like municipal bond funds, can be a smart way to reduce your tax bill, depending on your individual situation. Here are a few questions to consider before you decide:

Where are your assets held? If you're investing in a taxable account, a tax-exempt investment could help you avoid owing taxes on income you receive from that investment. However, if you're investing in a tax-advantaged account such as an IRA or 401(k), you won't benefit from the tax savings.

What tax bracket are you in? The higher your tax rate, the more valuable tax-exempt income can be. But for investors in lower tax brackets, taxable bonds may still offer better after-tax returns than comparable tax-free bonds.

Where do you live? If you live in a high-tax state, bonds issued by your state or local government may be exempt from both federal and state income taxes—and sometimes local taxes too. This "double" or "triple" tax exemption can make in-state municipal bond funds especially valuable for residents of high-tax states like California, New York, or New Jersey. If you live in a state with no income tax, like Florida or Texas, this benefit won't apply.

Keep in mind that tax-exempt funds typically offer lower yields than similar taxable bonds, so it's important to compare the after-tax returns of each to find out which one is right for you.

Vanguard tax-exempt funds

Vanguard offers dozens of tax-exempt funds that invest in municipal bonds and money market securities that are exempt from federal income tax. Tax-exempt funds can be especially useful if you're in a higher tax bracket and investing outside of a tax-advantaged account. You can explore your options by viewing Vanguard tax-exempt bond funds and Vanguard tax-exempt money market funds.

Looking for a tax-efficient investment?

Types of tax-advantaged accounts

Your investment choices play an important role in determining how much tax you owe—and so does the type of account in which you invest. With tax-advantaged accounts, you may be able to defer taxes on your investment earnings or, in some cases, make qualified withdrawals tax-free.1

Individual retirement accounts (IRAs)

IRAs allow you to save for retirement and take advantage of certain tax efficiencies. With a traditional IRA, your investments’ growth is tax-deferred until you make withdrawals in retirement. With a Roth IRA, any investment growth is tax-free, and you can make qualified withdrawals of your earnings tax-free in retirement.1

Employer-sponsored retirement plans

Employer-sponsored retirement plans, such as 401(k) and 403(b) plans, are among the most common tax-advantaged savings accounts. These accounts allow you to make pre-tax contributions and defer taxes until you take withdrawals in retirement. Many plans also offer a Roth option so you can contribute after-tax money and take tax-free qualified withdrawals in retirement.

529 plans

529 plans provide a tax-efficient option if you want to save for education expenses. Any investment growth in your 529 plan is tax-free, and withdrawals for qualified education expenses—including college or trade school tuition, books, room and board, and more—are tax-free at the federal level.2 In addition, some states offer tax deductions or credits on 529 contributions.

Health savings accounts (HSAs)

If you have a high-deductible health plan, HSAs offer a unique triple tax advantage. First, your HSA contributions are tax-deductible. Second, any earnings on the money in your HSA grow tax-free. And third, if you use the money for qualified medical expenses, your withdrawals, including any earnings, are tax-free. Many HSAs also include investment options, giving you the opportunity to potentially grow your savings tax-free.

Looking for help choosing the right account type for your investments?

How can tax-efficient investments fit into your overall strategy?

Tax-efficient investments are just one part of a smart investing plan. It's important to think about the types of investments you own (your asset allocation) and where you hold those investments (your asset location). For example, tax-efficient investments like index funds and ETFs are often best suited for taxable accounts, where fewer taxable payments may help keep your tax bill under control. On the other hand, it could make more sense to hold investments that generate regular income in tax-advantaged accounts like IRAs or 401(k) plans.

This approach, known as asset location, can help you make the most of your investments for tax savings. By being thoughtful about your investment choices and account types, you can help your money grow more efficiently over time.

Ready to move money into a tax-efficient account?

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1Withdrawals from a Roth IRA are generally tax-free if you are over age 59½ and have held the account for at least five years; withdrawals of earnings taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both. (A separate five-year period applies for each conversion and begins on the first day of the year in which the conversion contribution is made.)

2Earnings on nonqualified withdrawals may be subject to federal income tax and a 10% federal penalty tax, as well as state and local income taxes. The availability of tax or other benefits may be contingent on meeting other requirements. State tax treatment of withdrawals used for i) expenses in connection with enrollment or attendance at an elementary or secondary public, private, or religious school, ii) expenses related to apprenticeship programs, iii) student loan repayments, iv) Roth IRA rollovers, or v) expenses for postsecondary credentialing programs is determined by the state(s) where the taxpayer files state income tax.

All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.

There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

For more information about Vanguard funds, visit vanguard.com to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

Vanguard does not provide tax or legal advice. This information is general in nature and should not be considered tax or legal advice. We recommend you consult with a tax or legal advisor about your individual situation.

Municipal bond fund distributions, including any market discount recognized by the Fund's investments, may be taxable as ordinary income or capital gains. A majority of the income dividends that you receive from the Fund are expected to be exempt from federal income taxes. However, a portion of the Fund's distributions may be subject to federal, state, or local income taxes or the federal alternative minimum tax. You should consult your own tax advisor with respect to any particular U.S. or non-U.S. tax consequences of your investment in the Fund.

Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.

Note that some or all of the income from the U.S. Treasury obligations held in the fund may be exempt from state or local taxes. While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.

For more information about any 529 college savings plan, contact the plan provider to obtain a Program Description, which includes investment objectives, risks, charges, expenses, and other information; read and consider it carefully before investing. If you are not a taxpayer of the state offering the plan, consider before investing whether your or the designated beneficiary's home state offers any state tax or other benefits that are only available for investments in such state's qualified tuition program. Vanguard Marketing Corporation serves as distributor for some 529 plans.