By Ilana Polyak
There's an old adage in investing: It's not what you earn, it's what you keep. What difference does it make if your investments have huge returns if you have to give up a big slice to taxes?
Thankfully, you can be strategic about tax efficiency, and that strategy can make a significant difference in helping you build wealth.
Use these investment strategies to maximize your tax efficiency.
1. Defer taxes when you can.
A 401(k) is the workhorse of retirement savings, due to its high contribution limits ($19,000 for those 50 and under, $25,000 for those who are older), the convenience of payroll deductions and a possible match from your employer.
Traditional 401(k)s have several tax benefits, too. First, they can lower your taxable income, thereby reducing your annual income taxes. Next, the money grows tax deferred until you make withdrawals, which are allowed to do at age 59 1/2. If you were to pay taxes on your gains each year, your return would be lower.
Tax-deferred 401(k)s and IRAs aren't a free lunch, though. You will owe ordinary income tax for the full amount of your withdrawals. That's why it's wise to combine these accounts with other types of savings vehicles such as taxable brokerage accounts and Roth IRAs.
By diversifying your tax liability, you can better control how much you pay in taxes during retirement.
2. Pay attention to asset location.
You've heard about asset allocation—combining different types of asset classes in order to reduce risk—but have you heard about asset location? Asset location means placing different types of assets strategically into the type of account where they will get the best tax treatment.
For example, income-producing investments such as bonds or real estate investment trusts can provide ballast to a portfolio if stocks falter. But they are not tax efficient, because their income is taxable as ordinary income, rather than the more favorable capital gains rate. Holding them in a taxable account would therefore result in a hefty tax bill. Instead, you would want to store these investments in a tax-deferred account such as a 401(k) or an untaxed account such as a Roth. Meanwhile, keep growth stocks in taxable accounts because they can receive the lower tax rate there.
On the other hand, the income from most municipal bonds isn't taxed. (If you are a resident of Hawaii and purchase munis issued by the state of Hawaii, you won't pay state income tax either.) Holding these type of bonds in a 401(k) or IRA would be a waste of that account's tax advantaged status.
3. Evaluate potential investments by their tax efficiency.
We all want large investment gains, but don't be dazzled by an investment's high returns alone. It's important to understand how those returns were achieved. Were they the result of effective trading or short-term capital gains?
Before investing in a mutual fund or investment professional, check out the after-tax return, which shows you the results after taxes. That number may not be nearly as impressive.
Consider index funds which are generally (though not always) more tax-efficient than actively managed funds. Index funds only sell their underlying holdings if a stock is dropped from an index. By holding securities longer, those managers are able to limit their tax liability.
Using exchange-traded funds (ETF) is even more tax efficient. While mutual funds must pay out their capital gains each year, which shareholders must report and pay taxes on, gains on ETFs are only taxed when they are sold by you.
4. Harvest your tax garden.
Tax efficiency isn't a one-and-done kind of thing. It requires ongoing monitoring.
Tax loss harvesting is one strategy you'll want to employ annually, most likely near the end of the year. Whenever markets falter (which you can expect from time to time), look through your portfolio to find any securities that have declined during the year to sell. You can use those losses to offset gains elsewhere in your portfolio, and minimize your capital gains tax liability for that year. Any leftover loss can offset up to $3,000 of income, and you can carry forward losses indefinitely into future years until you've used them up.
What's more, you don't have to upend your investment allocation in the process of selling your securities. You can reinvest the proceeds in similar (not identical, otherwise you would run afoul of the wash sale rule and loss would be disallowed) securities and keep your investment allocation strategy intact.
Taxes are complicated. And when they involve investments, they become downright dizzying. Work with a knowledgeable investment advisor and tax professional who can guide you to an investment strategy that meets your goals—and isn't too taxing.
Ilana Polyak writes about the ways we can all make better financial decisions. She specializes in stories on investing, retirement, college funding, taxes, credit cards and insurance for consumers and financial advisors.