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Any time you make money from your investments you need to consider the impact taxes might have on your earnings. Fortunately, there are a range of tax-efficient investment strategies that can help minimize the bite taxes take out of your gains.
What is tax-efficient investing, and how does it work? By understanding the tax implications of different types of accounts, as well as the investments you choose (e.g. stocks, bonds, mutual funds), you can determine the most tax-efficient strategies for your portfolio.
Tax-efficient investing is important for two reasons. Not only can these strategies help you keep more money in your pocket, tax-efficient investing can enable you to keep more of your money invested in the market, with the potential for growth.
Read on for a description of each of these strategies to learn which might make the most sense for you. Because taxes can be complicated, be sure to consult a tax professional to address questions specific to your particular situation.
At a Glance: Types of Tax-Efficient Accounts
Investment accounts can generally be divided into three categories based on how they’re taxed: taxable, tax-deferred, and tax-exempt. Tax-deferred and tax-exempt accounts are generally used for retirement (like a 401(k) or Roth IRA), and they’re often considered more tax advantageous than a taxable account for long-term investing.
As a quick summary, here are the three main account types, their tax structure, and what that means for the types of investments you might hold in each.
|Types of Accounts||When Taxes Apply||Investment Implications|
(e.g. brokerage or investment account)
|Investors deposit post-tax funds and owe taxes on profits from securities they sell, and from interest and dividends.||Investors may want to choose investments with a lower tax impact (e.g. long-term stocks, municipal and Treasury bonds).|
|Tax-deferred (e.g. 401(k), 403(b), traditional, SEP, and Simple IRAs)||Investors contribute pre-tax money, but owe taxes on withdrawals (usually in retirement).*||Investments here grow tax free until funds are withdrawn, giving investors more tax flexibility when choosing securities.|
(e.g. Roth 401(k), Roth IRA)
|Investors deposit post-tax funds and don’t owe taxes on withdrawals.**||These accounts offer the most tax flexibility as investments grow tax free and investors withdraw the money tax free.|
|*Withdrawal rules and restrictions apply.|
|**Income limits apply. Withdrawal rules and restrictions apply.|
In order to understand tax-deferred and tax-exempt accounts, it helps to first understand taxable accounts, which are also called brokerage accounts or investment accounts. A taxable account has no special tax benefits.
Taxable accounts can be opened in the name of an individual or trust, or as a joint account. Money that is deposited into the investment account is post-tax, i.e. income taxes have already been paid or will be paid on those funds (similar to the money you’d put into your checking or savings accounts).
Taxes come into play when you sell investments in the account and make a profit. You may owe taxes on the gains you realize from those investments, as well as earned interest and dividends.
With some securities, like individual stocks, the length of time you’ve held an investment can impact your tax bill. Other investments may generate income or gains that require a different tax treatment.
- Capital gains. The tax on an investment gain is called capital gains tax. If an investor buys a stock for $10 and sells it for $50, the $40 is a “realized” gain and will be subject to either short- or long-term capital gains tax. The tax rate will be higher or lower depending on how long the investor held the investment — more or less than a year — and their personal income tax bracket and filing status.
- Interest. Interest that is generated by an investment, such as a bond, is typically taxed as ordinary income. In some cases, bonds may be free from state or local taxes. If you sell a bond or bond fund at a profit, short- or long-term capital gains tax could apply.
- Dividends. Dividends are distributions that may be paid to investors who hold certain dividend-producing stocks. Dividends are generally paid in cash, out of profits and earnings from a corporation — and can be taxed as short- or long-term capital gains within a taxable account.
But the terms are different when it comes to tax-deferred and tax-exempt accounts — and understanding where the differences lie is crucial to a tax-efficient strategy.
Tax-deferred Retirement Accounts
A 401(k), 403(b), traditional IRA, SEP IRA, and Simple IRA fall under the tax-deferred umbrella, a tax structure typical of retirement accounts. They’re considered tax efficient for a couple of reasons.
- Pre-tax contributions. First, the money you contribute to a tax-deferred account is not subject to income tax; you owe taxes when you withdraw the funds later, e.g. in retirement. Thus the tax is deferred.
This means the amount you contribute to a tax-deferred account for a given year can be deducted from your taxable income, potentially reducing your tax bill for that year.
Speaking hypothetically: If your taxable income for a given year is $100,000, and you’ve contributed $5,000 to an IRA, your taxable income would now be $95,000. And you wouldn’t pay taxes on the $5,000 contribution until you withdrew that money later, likely in retirement.
- Tax-free growth. The money in a tax-deferred retirement account grows tax free. Thus you don’t incur any taxes until the money is withdrawn.
- Potentially lower taxes. By deducting the contribution from your taxable income now, you may avoid paying taxes at your highest marginal tax rate. The idea is that investors’ effective (average) tax rate might be lower in retirement than their highest marginal tax rate while they’re working.
That said, it’s hard to bank on this particular tax advantage, as tax rates could change. And while some people tend to fall into a lower tax bracket when they retire, that’s not always the case.
The Tradeoffs of Tax-free Growth
Because of the advantages tax-deferred accounts offer investors, there are restrictions around contribution limits and the timing (and sometimes the purpose) of withdrawals.
- Contribution limits. The IRS has limits for how much you can save in tax-deferred accounts. For example, the maximum contribution for a 401(k) is $19,500 in 2021, with an additional $6,500 allowed for those age 50 and older. (An employer’s match is not counted toward the contribution limit.)
The maximum contribution to a traditional IRA is $6,000 for 2021, with an additional $1,000 for those 50 and over.
- Restrictions on early withdrawals. For 401(k) plans and IRAs, there is a 10% penalty if you withdraw money before age 59½, with some exceptions. You would also owe taxes on the amount you withdrew. Some exceptions apply (e.g. taking an emergency loan from your 401(k) and other qualifying events).
- Required withdrawals. At age 72, investors must begin to take withdrawals; these are called required minimum distributions, or RMDs, and this additional income can have tax implications. Although RMDs were suspended during 2020 owing to the pandemic, the policy is back in effect for 2021.
There are no RMDs for Roth IRAs (see tax-exempt accounts below).
The terms governing required distributions can be complex, and the penalty for missing or skipping an RMD can be onerous. Consult a tax professional for guidance.
Tax-exempt Retirement Accounts
When you contribute money to a tax-exempt account, you use post-tax funds — money that’s already been taxed. Although that means you can’t deduct contributions from your taxable income, the money grows tax free — just as it does in a tax-deferred account — but the real tax advantage here is that you get to withdraw the money free of taxes.
As with all investment accounts, there are different rules and restrictions that apply. For the purposes of this guide, we’ll focus on the rules pertaining to Roth accounts. The rules governing 529 plans and HSAs are somewhat different: These accounts do allow tax-free withdrawals, but only for qualified educational or health-related expenses.
Roth accounts, whether an online IRA account or a 401(k), are the only retirement accounts that permit tax-free withdrawals.
Because contributions to Roth accounts are made post-tax, there is also more flexibility on when the money can be withdrawn. You can withdraw the amount of your contributions tax and penalty free at any time. However earnings on those investments may incur a penalty for early withdrawal, with some exceptions.
For example, if you contributed $5,000 to a Roth IRA, and that amount grew to $7,000, you could withdraw the $5,000 at any time. But, with some exceptions, the $2,000 in investment gains could be penalized for early withdrawal if you’re younger than 59½ and have held the account for less than five years.
It’s also possible to earn too much to be eligible to contribute to a Roth IRA, so be sure to consult a tax professional on the current income limits for Roth accounts.
Contribution limits for Roth IRAs and 401(k)s are similar to their traditional, tax-deferred counterparts. For 2021, you can contribute a maximum of $6,000, with an additional $1,000 in catch-up contributions available to investors over 50. An investor can contribute up to $19,500 to a Roth 401(k), with an additional $6,500 in catch-up contributions.
A Roth account may make sense for an investor who has a low overall tax rate (and those who meet the income requirements). Because of this, Roth accounts tend to be popular with younger investors. Other investors may simply prefer to pay income taxes now and not have to worry about the tax bill in retirement.
Types of Tax-Efficient Investments
When deploying a tax-efficient investment strategy, it’s crucial to know how an investment is going to be taxed because ideally you’d want more tax-efficient investments in a taxable account. Conversely, you may want to hold investments that can have a greater tax impact in tax-deferred and tax-exempt accounts, where investments can grow tax free.
Next, it is helpful to know that some investment types are more tax efficient in their construction — so you can make the best investment choices for the type of investment account that you have. For example, ETFs are considered to be more tax efficient than mutual funds because they don’t trigger as many taxable events. Investors can trade ETFs shares directly, while mutual fund trades require the fund sponsor to act as a middle man, activating a tax liability.
There’s an important lesson here: Investments that are less tax efficient might make sense to hold in a tax-sheltered account, like a retirement account, because no profit-related taxes are levied on the earnings in those accounts.
Investment types that are more tax efficient might be better suited for taxable accounts, where an investor must pay both capital gains tax and income tax on interest earned.
Here’s a list of some tax-efficient investments:
- ETFs: These are similar to mutual funds but more tax efficient due to their construction. Also, most ETFs are passive and track an index, and thus tend to be more tax efficient than their actively managed counterparts (this is also true of index mutual funds versus actively managed funds).
- Treasury bonds: Investors will not pay state or local taxes on interest earned via Treasury bonds.
- Municipal bonds: These are bonds issued by local governments, often to fund municipal buildings or projects. Interest is generally exempt from federal taxes, and state or local taxes if the investor lives within that municipality.
- Stocks that do not pay dividends: When you sell a non-dividend-paying stock at a profit, you’ll likely be taxed at the long-term capital gains rate, assuming you’ve held it longer than a year. That’s likely lower than the tax you’d pay on ordinary dividends, which are generally taxed as income at your ordinary tax rate.
Note that actively trading stocks can have additional tax implications (more on that in the following section).
Typically, tax consequences will vary from person to person. A tax professional can help navigate tricky tax questions.
Tax-Efficient Trading Strategies
It may also be possible to minimize taxes by incorporating a few trading strategies as you manage your investments.
Minimizing Capital Gains Tax
Securities that are sold at an investment gain may be subject to capital gains tax (within a taxable account). But capital gains tax has two rates: short term, for investments held less than a year, when gains are taxed as ordinary income, and long term, for investments held longer than a year.
For investments held longer than a year, most investors will only pay either 0% or 15%, depending on their income tax bracket. Those who earn more than $434,550 (filing single) are subject to a higher 20% rate, but these tax rates can still be significantly lower than those applied to the capital gains on short-term investments. Short-term capital gains can be taxed up to 37% depending on your income tax bracket.
Within taxable accounts, there may be an additional way to minimize some of the tax bill created by selling profitable investments: tax-loss harvesting. This advanced move involves canceling out an investment gain with an investment loss.
For example, an investor wants to sell a few investments and the sale would result in $2,000 in capital gains. Tax-loss harvesting rules allow them to sell investments with $2,000 in total capital losses, effectively canceling out the gains. In this scenario, no capital gains taxes are due for the year.
Note that even though the investor sold the investment at a loss, the “wash sale” rule prevents him from buying back the same investment within 30 days after those losses are realized. This rule prevents people from abusing the ability to deduct capital gain losses, and applies to trades made by the investor, the investor’s spouse, or a company that the investor controls. Because this strategy involves the forced sale of an investment, many investors choose to replace it with a similar — but not too similar — investment. For example, an investor that sells an S&P 500 index fund to lock in losses could replace it with a similar U.S. stock market fund.
Tax-loss harvesting rules also allow an investor to claim some of that capital loss on their income taxes, further reducing their annual income and potentially minimizing their overall income tax rate. In 2021, this can be done with up to $3,000 in realized investment losses, or $1,500 if you’re married but filing separately.
Should your capital losses exceed the federal $3,000 max claim limit ($1,500 if you’re married and filing separately), you have the option to carry that loss forward and claim any amounts excess of that $3,000 on your taxes for the following year. For example, if you have a total of $5,000 in capital losses for this year, by law you can only claim $3,000 of those losses on your 2021 taxes. However, due to tax-loss carryover, you are able to claim the remaining $2,000 as a loss on your 2022 tax form in addition to any capital gains losses you happen to experience during the 2022 year. This in turn lowers your capital gains income and the amount you may owe in taxes.
Tax-Efficiency Through Diversification
A highly effective method for minimizing the tax impact on your investments is by diversifying your portfolio. A well-considered combination of taxable, tax-deferred, and tax-exempt accounts can help mitigate the impact of taxes on your investment earnings.
For example, with some investments — such as IRAs — your current tax bracket can have a substantial impact on the associated tax on withdrawals. Having alternate investments to pull from until your tax bracket is more favorable is a smart move to avoid that excess tax.
Also, with multiple investment accounts, you could potentially pull early retirement income from a tax-free Roth IRA and leave your company-sponsored 401(k) to grow until RMDs kick in.
Having a variety of investments spread across account types gives you an abundance of options for many aspects of your financial plan.
- Need to cover a sudden large expense? Long-term capital gains are taxed significantly less than short-term capital gains, so consider using those funds first.
- Want to help with tuition costs for a loved one? A 529 can cover qualified education costs at any time, without incurring a penalty.
- Planning to leave your heirs an inheritance? Roth IRAs are tax free and transferrable. And because your Roth IRA does not have required distributions (as a traditional IRA would), you can allow the account to grow until you pass it on to your heir(s).
Creating a Tax-Efficient Investment Strategy
Once you understand the tax rules that govern different types of investment accounts, as well as the tax implications of your investment choices, you’ll be able to create a strategy that minimizes taxes on your investment income for the long term. Ideally, investors should consider having a combination of tax-deferred, tax-exempt, and taxable accounts to increase their tax diversification. To recap:
- A taxable account (e.g. a standard brokerage account) is flexible. It allows you to invest regardless of your income, age, or other parameters. You can buy and sell securities, and deposit and withdraw money at any time. That said, there are no special tax benefits to these accounts.
- A tax-deferred account (e.g. 401(k), traditional IRA, SEP IRA, Simple IRA) is more restrictive, but offers tax benefits. You can deduct your contributions from your taxable income, potentially lowering your tax bill, and your investments grow tax free in the account. Your contributions are capped according to IRS rules, however, and you will owe taxes when you withdraw the money.
- A tax-exempt account (e.g. a Roth IRA or Roth 401(k)) is the most restrictive, with income limits as well as contributions limits. But because you deposit money post-tax, and the money grows tax free in the account, you don’t owe taxes when you withdraw the money in retirement.
Whether you’d like to open a taxable, tax-deferred, or tax-exempt account, an online investing app like SoFi Invest® can help. There are no SoFi fees to open an account and to buy investments. Trading stocks, ETFs, and cryptocurrency is user-friendly with SoFi Invest. Investors can stay up to date on breaking news, conduct research on investments, and place trades, all from within the SoFi app.
Best of all, SoFi offers access to financial planners at no additional charge. Question about saving, investing, or debt-payoff strategy? No problem. SoFi financial advisors are here to help.
For additional questions or specific advice regarding your personal tax situation, it’s best to consult a tax professional.
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