Three Tips for Tax Efficient Investing

Tax Efficient Investing involves three broad strategies, according to financial experts, the maximum use of tax-advantaged accounts, tax-advantaged asset allocation and tax efficient trading.

The three-pronged strategy helps improve after-tax returns, the earnings an investor gets to keep after the government has taken its share. “Tax issues are important in evaluating any investment,” said Joel Dickson, of Vanguard’s Investment Strategy Group. “Ultimately, your investment return is not just about how much you earn it’s about how much you keep.”

Taxes can reduce investment gains by 40 percent or more, after factoring in federal, state, and local income taxes, the alternative minimum tax and capital gains taxes according to Doug Lockwood, The Smarter Investor blogger. Tax-deferred and tax-free accounts, including IRAs, 401(k)s and annuities, allow earnings to compound tax-deferred until withdrawal. Most investors spend their IRAs and 401(k)s in retirement, when their tax burden is lower, said Lockwood. In some cases, contributions to IRAs and 401(k)s can be made on a pre-tax basis or can be tax deductible. Contributions made to Roth-style plans are not tax deductible, but earnings can be withdrawn tax free.

Tax efficient investing also involves strategic asset allocation that takes full advantage of the tax shelters offered by retirement and college savings plans. Investments yielding taxable gains – such as actively managed mutual funds and dividend paying stocks – can be housed in tax-advantaged funds. Investments yielding minimal taxable gains – such as federally tax-exempt municipal bonds and certain exchange-traded funds – can be allocated to accounts subject to taxes.

The third broad component of tax-efficient investing is trading with tax consequences in mind. Losses in taxable accounts can be harvested to offset investment gains, according to Dickson, of Vanguard, while trades yielding taxable gains can be concentrated in tax-sheltered accounts. Exchange-Traded Funds, or ETFs, are index-based pooled investments that offer tax efficiencies through relatively low turnover rates that tend to result in lower capital gains distributions.

Millionaire Corner research shows that savvy affluent investors employ tax efficient investing strategies, but even high net worth investors – those with investable assets of $5 million to $25 million – do not take full advantage of tax-advantaged accounts. Less than one-third invest in ETFs and fewer than half own municipal bonds, according to our fourth quarter study of financial product ownership. Though 92 percent have an IRA account, 58 percent have a 401(k) and 16 percent have a 529 college savings plan. A 529 can be a triple tax efficient investing option because investments not only grow tax free and are withdrawn tax free when used for approved purposes, but some states also allow tax breaks for contributions to the plans.