A Guide to Tax Efficient Investing

by | Jun 8, 2022 | Financial Planning, Insights, Tax Planning, Wealth Management | 0 comments

Taxes are a big part of life, most notably in that rush to file your tax return before the annual deadline. But taxes play a major role in your investment strategy, as well. In fact, keeping a close eye on taxes is one of our 6 Keys to Successful Investing. Earning a strong return from your portfolio is important, but how much you keep, not how much you earn, is what matters in the end. So how can you ensure that taxes don’t take too big of a bite out of your nest egg? Here are six ways to invest tax-efficiently, reduce taxes, and keep more in your pocket.

1. Hold the right investment in the right account.

You’re investing to earn a return, to grow your wealth. With a stock, your return comes from two possible sources: an increase in the share price or a dividend, a portion of company profits distributed to shareholders. When a dividend comes in, you’ll pay taxes right away, but you won’t pay tax on the share price increase until you sell it.

You’re likely buying this stock in one of two kinds of accounts:

  • Taxable accounts like a brokerage account pays tax on interest, dividends, and capital gains as your investment grows.
  • Tax-advantaged accounts like a IRAs, Roth IRAs, and 401(k) avoid or defer taxes on income or capital gains as your funds grow.

As you build your nest egg, you can reduce your tax bill by holding investments that generate higher income and capital gains in tax-advantaged accounts and individual stocks or funds like ETFs that tend to be more tax-efficient in taxable accounts.

2. Save as much as possible into accounts that avoid taxes.

Tax-advantaged accounts, like an IRA, Roth IRA, 401(k), cash values in certain life insurance policies, and other retirement accounts can save taxes today and tomorrow. These break down into two categories:

  • Tax-deductible accounts like 401(k), Simple & SEP IRA, and cash balance pension plans allow you to deduct your contributions from taxable income, reducing your income tax that year. Funds aren’t taxed while they grow in the account, but you’ll pay income tax on everything you withdraw in retirement.
  • Tax-free accounts like Roth IRA and Roth 401(k) won’t provide a tax deduction today, but you’ll be able to withdraw everything, including growth, tax-free in retirement.

Think of these two strategies like hot and cold knobs on the bathtub. When it comes to retirement income, you’ll want some of each to create the right tax temperature by controlling how much taxable and tax-free income you take each year.

 3. Hold investments for at least a year whenever possible.

When you sell an investment for a profit, this is called a capital gain. And, you guessed it, you’ll pay tax on that gain. But if you hold that investment for longer than one year, you’ll pay a lower rate than if you sell in less than one year. So, when selling investments that have appreciated, look for ones you’ve held for longer than one year to lower that tax bill.

 4. “Harvest” losses to reduce taxes.

This is also called tax-loss harvesting. During a drop in the market, you can sell investments that are down, replace them with similar investments, and use the loss to offset other investment gains and up to $3,000 of earned income. Any losses not used to offset gains this year will carry forward to be used in future years. When deciding what holdings to sell, start with stocks that no longer fit your investment goals or positions you were already looking to replace. See Can Losses Increase My Investment Return? for more.

5. Be smart with your charitable donations.

If you sell investments when you give to your favorite charity, you’re likely generating capital gain tax along the way. Instead, consider donating stock directly to the charity because they can sell the stock with no tax. Better yet, you get a tax deduction for the entire value of the stock, not just what’s left after you pay tax. If you have a particularly high income year or want to give over time, consider using a Donor Advised Fund, one of the most flexible, tax-efficient giving accounts available to anyone!

6. Use Alterra’s resources to learn more about specific strategies.

Read these articles to learn how to use tax-efficient strategies for these specific goals.

There are many more tax strategies to consider, but these are a few to get you started.

Taxes are important, but they shouldn’t drive your investment strategy.

Taxes are just one component in a comprehensive investment strategy. Your plan should start with your goals, tolerance for investment risk, and amount of time you have to let your investment grow. From there, you can use these strategies to manage and reduce taxes, sending less to the government and keeping more to enjoy your life, provide for loved ones, and give to causes you care about!

Alterra Advisors - Josh Whelan

Ryan Colis

Partner, Financial Advisor

About the Author

Ryan is a problem solver. He has a distinct ability to create a simple solution for very complex puzzles. So, naturally, he’s an integral part of our team. His favorite part of his role at Alterra is the analysis – whether analyzing a financial plan or reviewing an investment portfolio. However, the profession allows him to share that passion with clients by helping them navigate financial complexities as they collaborate on achieving their personal and financial goals.

After completing his undergraduate degree in Business Management, Ryan and Grant met by chance, developed a rapport and have been working together ever since. Ryan has continued his formal training in finance by earning his CFP and CFA designations.

The “Alterra” name was coined by joining the Latin roots “alter”, the origin of the word “altruism” with “terra” meaning earth or land. This name reflects the company philosophy of “clients before profits” and providing firmly grounded advice.

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