Mastering the Art of Tax-Efficient Investing: Maximizing Returns While Minimizing Taxes

Investing can come with many benefits, particularly the potential for growth and income to support both sort-and long-term aspirations.  With the benefits of that growth also comes the potential for taxes, which can lead to a significant burden and impact to your bottom line if not managed efficiently.  This can especially be detrimental to those in higher tax brackets.  In this article, we will cover the art of tax-efficient investing – what it is, the benefits, and strategies you may consider.  We also discuss the benefits of working with a trusted, qualified financial advisor, such as our team at Tenet Wealth Partners, to help create tailored tax-efficient strategies that are personalized to your situation, needs, and goals.

 

Understanding tax-efficient investing

Simply put, tax-efficient investing is a strategy that focuses on maximizing investment returns while strategically minimizing tax liabilities. It involves utilizing various techniques and investment vehicles to optimize after-tax returns, allowing investors to keep more of their hard-earned money and compound your wealth over the long haul.  In other words, you still maintain a focus on growing your investments but also try to keep more in your pocket by potentially reducing the tax bite. This approach is crucial because taxes can significantly erode investment gains over time, making tax efficiency a key consideration in wealth accumulation and preservation.

Before diving into more specifics about tax-efficient investing, how can taxes impact your investment returns?  When investing in a non-retirement account (i.e., brokerage, trust, TOD, or joint account), you may earn income from your investments via dividends and interest, both of which are taxable to you.  Additionally, if you sell an investment for more than you paid for it, you will be assessed capital gains tax. Depending on your tax bracket and the type of investment, you could be paying a significant portion of your returns in taxes. For example, if you’re in a high tax bracket and earn substantial capital gains, you could be paying north of 20% in taxes on those gains.  Over time, these taxes can eat into your investment returns and hinder the growth of your portfolio.

Now, let’s delve into specific tax-efficient investing strategies and their benefits:

 

1.) Tax-Loss Harvesting: Turning Losses Into Opportunities

One effective strategy is tax-loss harvesting, which involves intentionally and strategically selling investments at a loss in order to offset realized capital gains, which may potentially reduce taxable income and taxes due. It’s like turning lemons into lemonade by using investment losses to your advantage. Additionally, if your capital losses exceed your capital gains at the end of the year, you can use up to $3,000 of those losses as a capital loss deduction on your tax return.  Any remaining net losses above that $3,000 can then be carried forward to use in future years.

If utilizing this strategy, it is very important to be mindful of the wash-sale rule, which prohibits buying back a substantially identical investment within 30 days (before or after) of selling it for a loss. Violating this rule could result in disallowed losses.  One consideration to remain invested yet not violate this rule is to reinvest the proceeds from the sale into a similar (but not substantially identical) security.  For example, if you sell a Technology sector stock for a loss, you may be able to reinvest into a diversified Technology-focused mutual fund or ETF for the 30-day period.  After the 30-day window is passed, you can consider then going back into the original security you sold at a loss if appropriate.  However, given these nuances and complexities, it is highly recommended to work with a professional, fiduciary financial advisor, specifically an advisor with expertise in tax-efficient investing like our team at Tenet, if you are looking to implement this strategy.

2.) Asset Location: Placing Investments Wisely Across Different Account Types

Another key tax-efficient strategy is asset location.  Asset location involves strategically placing your investments in different types of accounts to minimize your tax liability. More specifically, tax-efficient investments (e.g., stocks, passive index ETFs, municipal bonds/bond funds) are placed in taxable accounts, while tax-inefficient ones (e.g., taxable bonds/bond funds, actively managed mutual funds) are held in tax-advantaged accounts like IRAs, Roth IRAs, and 401(k)s. It may also be beneficial to consider the potential return profiles and opportunities for where you place assets.  For example, high growth asset classing may be best for IRAs, especially Roth IRAs, given that you don’t pay taxes on growth or income while the funds are invested in those accounts.  On the other hand, investments with a lower return profile/potential, such as municipal bonds/bond funds, may be appropriate for taxable accounts, especially when you consider the fact that municipal bond interest is Federal tax-free.  Think of it as organizing your financial house to optimize your after-tax returns.

3.) Direct Indexing: Customizing Your Portfolio

Direct indexing is a sophisticated strategy that has been gaining in popularity over the last several years.  It involves owning individual securities directly instead of through mutual funds or ETFs, and then tracking the risk and performance of a designated index, such as the S&P 500.  Think of it like creating your own, personalized index fund, except, you actually own the individual securities instead of just shares of a fund.  Direct indexing allows for greater control over tax management, including tax-loss harvesting at the individual security level. You can also customize security selection based on preferences and values, or considering a large stock concentration.  For example, if you want to avoid tobacco stocks, you can set a restriction from owning those types of companies, or if you have a large 10%+ position in one stock, you can ensure that more of that stock is not purchased while also diversifying further into other sectors.  The sky is the limit in terms of how much you can customize your direct indexing strategy while also maintaining tax-efficiency benefits.

4.) Individual Stocks and ETFs vs. Active Mutual Funds: Efficiency Matters

Choosing individual stocks and ETFs over actively managed mutual funds can also enhance tax efficiency. Mutual funds, particularly those that are actively managed with high turnover, often distribute unexpected year-end capital gain dividends, leading to an unwanted tax surprise for investors. These year-end distributions can even be significant enough to push you up into the next tax bracket and potentially lead to more tax due come April. In contrast, individual stocks and ETFs offer more control over tax consequences, including the ability to time capital gains and losses strategically.  As referenced earlier as part of asset location, it is important to consider utilizing actively managed funds in tax-advantaged retirement accounts if possible, while incorporating mainly individual stocks and ETFs in your taxable non-retirement accounts.

5.) Utilizing Tax-Advantaged Retirement Accounts: A Powerful Tool

Utilizing tax-advantaged retirement accounts, such as 401(k)s, IRAs, Roth IRAs, and HSAs, is key to tax-efficient investing. These accounts offer tax deferral or tax-free growth benefits, allowing investments to compound and maximize returns without immediate tax consequences. It’s like planting seeds in fertile soil, allowing your investments to grow uninterrupted by taxes until retirement.

To review the benefits of these accounts, Traditional IRAs and 401(k)s allow you to contribute pre-tax dollars, reducing your current taxable income. The earnings in these accounts grow tax-deferred, meaning you don’t pay taxes on the gains until you withdraw the funds in retirement. This tax-deferred growth can significantly enhance your investment returns over the long term. Roth IRAs and Roth 401(k)s, on the other hand, allow you to contribute after-tax dollars. Although you don’t receive an immediate tax deduction, the withdrawals in retirement are tax-free, providing tax-free growth on your investments. This can be particularly beneficial if you expect to be in a higher tax bracket in retirement.  Lastly, Health Savings Accounts (HSAs) offer a unique triple tax advantage. Contributions are tax-deductible, earnings grow tax-deferred, and withdrawals for qualified medical expenses are tax-free. If you’re eligible to contribute to an HSA, it can serve as a powerful tax-efficient investment vehicle in addition to the other referenced.

6.) Managing the Timing of Your Capital Gains

We touched on generating losses earlier, but now we turn our attention to the importance of managing realized capital gains.  Holding investments for a year or longer may significantly reduce taxes by converting short-term capital gains (investments sold in less than a year) into lower-taxed long-term gains (investments sold after a year or longer). If investors are not careful, selling to early can come with a hefty tax bill given that short-term capital gains are taxed at your ordinary income tax rate, while long-term capital gains are taxed at 15% or 20% (depending on your tax bracket).

Diversification and tax efficiency

Diversification is a fundamental principle of investing in and of itself, but it can also play a key role in tax efficiency. By diversifying your investments across several different asset classes and sectors, you can potentially reduce the impact of taxes on your overall portfolio because you may have more options available to implement the above strategies.

As an example, if you hold a diversified portfolio of 10 US stocks, 4 US stock funds, 3 international stock ETFs, and 3 bond funds, you have the flexibility to strategically sell from those 20 total investments with losses to offset gains in other asset classes. This can help minimize your tax liability while maintaining a well-diversified portfolio.

It’s important to note that diversification alone does not guarantee tax efficiency. You still need to consider specific strategies mentioned, such as asset location, tax-loss harvesting, and other tax-efficient strategies, when building and managing your diversified investment portfolio.

Working with a financial advisor for tax-efficient investing

As referenced earlier, tax-efficient investing can be complex and challenging to accomplish alone, especially when considering all of the nuances and tax laws to be aware of.  This can become even more challenging when trying to balance strategic decisions with your individual financial situation, needs, and goals. This is why working with a qualified, fiduciary financial advisor can be invaluable in helping you navigate the intricacies of tax-efficient investing and maximize your after-tax returns.  A financial advisor can assess your unique circumstances, develop a personalized tax-efficient investment strategy, and provide ongoing guidance to ensure you stay on track.

More specifically, financial advisors can provide personalized guidance tailored to your specific financial goals and tax situation. They can then help implement tax efficient strategies customized to your situation, like tax-loss harvesting, asset location, and direct indexing. Secondly, advisors stay abreast of the ever-changing landscape of tax laws and regulations, ensuring compliance and maximizing tax-saving opportunities. Thirdly, advisors can offer ongoing monitoring and adjustments to your investment portfolio along the way to adapt to changing tax environments and optimize tax efficiency over time.

Taking it a step further, it is most advisable to work with a financial advisor with a strong background and specific expertise in tax-efficient investing, as well as a fiduciary duty to act in your best interest.  At Tenet, tax-efficiency and minimization is a core principle of our investment philosophy and approach.  Our team of CERTIFIED FINANCIAL PROFESSIONAL™ professionals have the expertise, background, and focus to create personalized tax-efficient strategies for our clients’ benefit.  We also have the expertise and experience of integrating these tax-efficient strategies into our clients’ comprehensive financial plan to ensure that these strategies work harmoniously with their broader plans and ambitions.

Conclusion: Achieving financial goals through tax-efficient investing

Mastering the art of tax-efficient investing can be a vital step towards achieving your long-term financial goals. By understanding the impact of taxes on your investment returns and implementing tax-efficient strategies such as asset location, tax-loss harvesting, and utilizing tax-advantaged accounts, you can potentially maximize your after-tax returns and compound your wealth effectively.

While tax-efficient investing can be complex, working with a qualified, fiduciary financial advisor can provide the personalized guidance and expertise needed to navigate the intricacies of tax laws and optimize your investment strategy. Our team at Tenet are focused and experienced in tax-efficient investing, and we stand ready to guide you through this process and create tax-efficient strategies tailored to your situation and needs.  Don’t hesitate to contact our team with any questions or schedule a meeting with us today.

 

Registered Representative of Sanctuary Securities Inc. and Investment Advisor Representative of Sanctuary Advisors, LLC. Securities offered through Sanctuary Securities, Inc., Member FINRA, SIPC. Advisory services offered through Sanctuary Advisors, LLC., a SEC Registered Investment Advisor. Tenet Wealth Partners is a DBA of Sanctuary Securities, Inc. and Sanctuary Advisors, LLC.

The information provided in this communication was sourced by Tenet Wealth Partners through public information and public channels and is in no way proprietary to Tenet Wealth Partners, nor is the information provided Tenet Wealth Partner’s position, recommendation or investment advice.

This material is provided for informational/educational purposes only.  Any hypothetical examples provided within this material are for illustrative purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Investments are subject to risk, including but not limited to market and interest rate fluctuations.