Taxes are an unfortunate side effect of successful investing, but there are ways to avoid it. You can build a tax efficient investing strategy to help lower those taxes over time. More importantly, it will leave more money in your pocket to reinvest, compound, and grow.

A tax efficient investment strategy is nothing new. It’s been used by the wealthy since tax codes were enacted. It’s legal and you don’t need a high-priced CPA to put an effective strategy together. If you know the current tax rates, you are half way there. After that you just need to know how to use the tax code in your favor. In order to do that we need to start with the basics.

What Is Tax Efficient Investing?

Taxes eat into your investment gains like any other costs. This puts a limit on how your money grows. But thanks to our overly complex tax system, you have ways to reduce, suspend, or eliminate them.

The basic tax efficient investing strategy should lower your tax liability based on your financial goals both now and in the future. When done right, it should maximize your after tax dollars, which is the ultimate goal.

You’ll have to take the tax consequences into account when making any investment decision. In order to do this, you’ll need to know a few things:

The current tax code

The right asset allocation to use

The types of accounts to use

The time to hold each investment

The tax code will decide how you use the different accounts, investments, and allocation when building your tax efficient strategy.

Know The Tax Code

The biggest obstacle to any tax efficient investing strategy is a constantly changing tax code. With our progressive tax system (and political reelection promises) you will deal with tax rate changes often. Trying to figure out the future tax rates decades from now is useless, if not impossible. Instead, focus on your financial goals and how the current rates affect each one. You can always make adjustments when things change.

Income, interest, dividends, and capital gains are all taxed. Interest is considered income and is taxed at the same rates. Dividend and capital gains tax rates are more complicated. If you’re not sure what the current tax rates are, you can find it here.

Capital gains tax is divided between short-term (one year or less) and long-term (more than one year) capital gains. Short term capital gains are taxed at the same rate as your income. Long term capital gains are given a lower tax rate. Keep this in mind when you’re buying and selling investments.

When the tax code favors one stream over another, you should adjust your asset allocation to take advantage of the difference.

Tax Efficient Investments

You will only get so far knowing the tax code. The real success comes from your asset allocation and taking advantage of tax efficient investments. This becomes more important as your income tax rates rise.

This is where tax-free bonds are used. Municipal bonds and to a lesser degree U.S. Treasuries fall into this category. Municipal bonds are exempt from federal income tax. This can have a big impact when you rely on investments to pay you part or all of your income. U.S. Treasuries are only exempt from state and local income tax and only benefit those investors with a high state income tax.

How much you benefit from this will depend on your income tax rates. When choosing a municipal bond or bond fund, first use the taxable equivalent yield chart to get an apples to apples comparison against taxable bond yields. If the risks are the same, choose the higher yielding bond, even if it happens to be a taxable bond. Remember, your goal is to maximize your after tax dollars, not just to cut your taxes.

When using tax efficient investments it is important to be aware of the type of account you use.

Taxable Or Tax Advantaged Accounts

Imagine how hard saving for retirement would be if you were taxed every year on that savings. It wouldn’t look good. That’s the reason retirement accounts are such an advantage. But it comes with the price of limited access. So, taxable bank and brokerage accounts have a place in your tax efficient strategy too.

Taxable Accounts

The biggest advantage of taxable accounts is the easy access to funds. It’s also the biggest downfall. You are quickly hit with capital gains tax each time you sell an investment.

With that in mind, investments in taxable accounts should have a long-term focus. That means holding stocks, bonds, or mutual funds for at least one year to avoid the short-term capital gains tax.

In addition, municipal bonds and other tax efficient investments are perfect for taxable accounts. The point here is to save the short-term investing and trading for your retirement accounts where you can avoid the higher short-term capital gains tax entirely.

Tax Advantaged Accounts

Your 401k, 403b, pension, traditional IRA, and Roth IRA fall under tax advantaged accounts. All but the Roth IRA offers tax-deductible contributions and allows you to grow your money tax-free until its withdrawn at retirement. At that point it’s taxed as income, where you might be in a lower tax bracket.

Alternatively, the Roth IRA takes after tax contributions and allows your money to grow and be withdrawn tax-free. The hope being that you are in a higher tax bracket at retirement.

The tax advantaged account you choose will depends on what accounts your work offers, on your income, and qualifications. For instance, a Roth IRA has income limits and at a certain point loses it’s luster to the tax-deductible accounts as your income tax rate climbs.

Either way, you get the best tax efficient return on your investments taking full advantage of these accounts. Just keep in mind that penalties and age restrictions limit when you can take money out.

Summary

Taxes are another investment cost like transaction fees that eat into your returns, limiting your ability to grow your money. A good tax efficient investing strategy will allow you to avoid some of the higher costs of taxes. Remember, it’s a balancing act between lower taxes and higher after tax dollars. Don’t let a need to lower taxes steer you away from money-making opportunities either. What matters most is how much you keep after taxes.