Because taxes are complex, it can be challenging to make your investments tax-efficient. This article offers ideas to help you make decisions that are tax-wise for your circumstances. The ideas are about:

• Perspectives. It's important to be tax-aware from three perspectives: broad (what types of accounts are tax-advantaged?), intermediate (what funds or investments are most tax-efficient?), and narrow (what transactions have tax consequences?).
• Goals. Special strategies may be necessary for objectives such as saving toward a major purchase or holding a reserve fund when retired. Cases like these may span the tax-boundary for long-term and short-term holdings or allow placement in either tax-free or taxable accounts.
• Advice. Certain questions may be worth reviewing with your tax adviser, if you have one. And some issues are so complex that almost everyone really should consult a professional before making a decision.

​When reading this article, be aware that Able to Pay LLC is presenting it for your information and education, and makes no claim to be a tax professional or certified financial planner. Verify your personal investment decisions by consulting www.irs.gov and your state's tax authority, or by reviewing them with your own adviser or tax-planning software.

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Perspectives

​Investing is necessarily a series of decisions. What types of accounts should you have? What investments or funds should you hold? What transactions should you initiate or avoid? From each of these perspectives - accounts, investments, and transactions - it's advantageous to be tax-aware.

Accounts

Employers' Retirement Plans.​ Your current employer's 401(k), 403(b), or 457 retirement plan may be the first option to consider when seeking to invest in a tax-efficient manner. Some key considerations:

• Taxes will be deferred until you are retired and begin taking withdrawals. Normally, withdrawals become mandatory once you reach 70½ years of age. However, If you continue working past age 70½, your current employer's plan might allow you to defer withdrawals and taxes until you stop working. Check whether your employer offers this option.
• There will be penalties on taking early withdrawals, typically before age 59½ years. However, there are exceptions. Be sure you understand how these rules work in your employer's plan.
• If your income meets the IRS rules for contributing to an IRA or to a Roth account, it may be advantageous to contribute some or all of your retirement savings to an IRA, rather than your employer's plan. See the section below on Goals.
• On the other hand, if you are fortunate enough to be certain your taxable income in retirement will be higher than your taxable income now, you may want to pay the taxes now and invest in a taxable account, rather than your employer's plan. Your tax adviser or software such as ESPlanner could help you evaluate the options.

Individual Retirement Accounts (IRA). Your own IRA account is often an excellent place to invest, because taxes will be deferred until you begin taking withdrawals. Some key considerations:

• If your income is high, you may have to pay taxes on the income before you contribute it to an IRA. However, once the money is in your IRA, gains on the investment are tax-free until you withdraw them.
• If your income is low enough to qualify for a Roth IRA, it is very often an excellent plan to contribute to it, rather than to a traditional IRA.
• Often, a rollover IRA account is an excellent placement for investments originally made in a former employer's retirement plan, especially when the IRA is held at a low-fee, high-quality firm. Employers' plans very often have higher fees than an IRA; to find the costs of your employer's plan, see this related article. When doing a rollover, be sure to execute it as a firm-to-firm transfer (which is tax-free) not as a withdrawal that goes through your checking account (which may invoke a tax-penalty).
• Generally, withdrawals before age 59½ will invoke a tax-penalty.
• After age 70½, you will have to take withdrawals every year, even if you are still working.
• If you are self-employed, investigate the special types of IRA and retirement accounts that may be available to you.

529 College Savings Plans. For college savings, including graduate school, 529 plans are very attractive for two reasons. First, after money is contributed to a 529 account, it grows tax-free; no additional taxes are paid when money is withdrawn, provided it is used for a qualified educational purpose. Second, some states offer a deduction of state taxes for money contributed to the state's 529 plan. That said, you should be aware of certain points:

• Your state's 529 plan may have high fees. As a good rule of thumb, able2pay.com recommends funds that charge no more than 0.4% ($4.00 per $1000 per year). If the 529 plan for your state charges more, consider investing in a lower-fee 529 plan in another state. You are not restricted to your own state's plan. For some examples, see our article How Long?, which provides examples of low-fee options for 529 plans, both in the near-term (the student is enrolled now or enrolling soon) and in the long-run (the student's enrollment is several years away).
• A 529 account is not part of your estate. It accrues to its beneficiary and bypasses the probate process.
• You can invest in a 529 plan for which you are yourself the beneficiary, regardless of your age.​
• If a 529 plan has a residual balance after the beneficiary's education is completed, you as the account manager have two options. You can roll over the account to a member of your extended family as the new beneficiary, with some restrictions; or you can withdraw the balance, pay a 10% tax penalty on the earnings (not on the original contributions), and use the remainder for any purpose.
• The expenses you can reimburse from a 529 plan are very broad, but there are some exceptions. See the section on Alternate Placement, below.

For a good overview of tax-regulations for 529 plans, read this FAQ sheet from the official source, the IRS.


Treasury Direct Accounts. The U.S. Treasury offers an online service, www.treasurydirect.gov, that makes it easy to buy and redeem Treasury bonds, notes, and bills. There are no fees whatsoever, low minimum investments, easy ways to reinvest, and automatic transfers to and from your bank account. Regarding taxes, the key points are these:

• Interest payments from Treasury securities are subject to U.S. income taxes, but not to state taxes.
• Treasury Direct is not available within an IRA, employer's retirement plan, or 529 plan.

Thus, a Treasury Direct account is tax-appropriate mainly when your financial plan includes investing in bonds in a taxable account. Under those circumstances, Treasury Direct may be a better choice than a money market fund or a bond mutual fund or ETF, which may charge fees of 0.1% to 0.4% or higher.

Taxable Accounts. For ordinary retail investors, tax-advantaged accounts may be limited to the types listed above. Your remaining tax-wise options are to purchase appropriate types of investments within a taxable account and to execute transactions in ways that avoid unnecessary taxation. These options are described next.

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Investments

​Municipal Bonds. State, county, and city governments and agencies can issue bonds that are exempt from federal, state, and city taxes. Because of the tax-exemption, they normally pay a lower interest rate than taxable corporate bonds and U.S. Treasuries. The risk of default is low, but not zero, so diversification is prudent. Key considerations are:

• Municipal bonds are ill-advised within a tax-advantaged account such as an IRA. Instead, invest in corporate or Treasury bonds.
• If your federal income tax rate is low, the federal tax exemption of municipal bonds may be small or non-existent. The net interest rate you earn after taxes and fees may be equal or better if, instead, you buy taxable bonds.
• If your state of residence has income taxes, and your taxable income is high, municipal bonds issued by agencies in your state may be doubly advantageous.
• Purchasing municipal bonds directly from the issuing agency may require some effort and brokerage fees. Unless you are familiar with this terrain, you are likely to pay lower fees and get better diversification by purchasing a mutual fund or ETF. iShares, State Street SPDR, and Vanguard offer low-fee, nationally diversified municipal bond ETFs. Betterment, Wealthfront, and Schwab include such ETFs within their automated portfolios. For state-specific funds, Vanguard's mutual funds may have the lowest fees, although low-fee funds may also be available from other firms or ETFs for large, high-tax states such as New York and California.

Treasury Bonds, Notes, and Bills. As a general guideline, if you are seeking to limit state and federal taxes in a taxable investment account, municipal bonds are likely to be a better option than U.S. Treasury Bonds, Notes, and Bills. That said, Treasuries have properties that make them good investments for other reasons; see the article Diversify!; or search our News page for posts on bonds and inflation; or use our calculators.

Index Funds. Mutual funds and ETFs that track a broad index may be advantageous in a taxable account. The reasons are related to how such funds execute transactions, which are discussed in more detail below. Briefly, index funds will tend to:

• Hold securities longer than actively managed funds, thus qualifying for favorable tax-rates on long-term capital gains.
• Have less turnover than actively managed funds, thus having fewer taxable sales to report.

As a general practice, if you are considering investment in an actively traded fund, try to buy it within a tax-advantaged retirement account. Within a taxable account, use a comparable indexed fund instead.

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Transactions

Long-Term Capital Gains. With just a few exceptions, if you hold any asset for a year or more, then sell it at a profit, your gain is subject to a lower federal tax-rate than the rate that applies to your other income. Stocks, bonds, mutual funds, and ETFs held longer than a year all qualify for the lower rate. Depending on your state, there may also be state taxes on capital gains, and they may or may not qualify for reduced rates. To learn the basic facts regarding federal rates, including the exceptions, read this short explanation from the IRS. In order to manage your own transactions so as the qualify for the lower rate:

• Read our article on rebalancing to learn how to rebalance effectively but rarely, thus keeping your portfolio aligned with your targets while limiting the frequency of sales. Smart rebalancing is important in a taxable account. However, in a tax-advantaged account such as an IRA, 401(k), or 403(b), you can rebalance without concern, because sales won't generate taxable income.
• In a taxable account, pay close attention to two properties of your mutual funds and ETFs. The first is their turnover rate (the annual percentage change in what the fund owns). The lower the turnover rate, the more likely it will be that sales made by the fund will qualify for long-term capital gains. Second, look at the fund's history of distributing capital gains. Taxable income is minimized when both the turnover rate and the distributed capital gains are small. Often, index funds are best on both counts; however, there can be exceptions.

​Qualified Dividends. The reduced federal tax-rate for long-term capital gains also applies to qualified dividends. Essentially, these are payments made by a company whose stock is owned by you or your mutual fund or ETF, provided that the stock-ownership persists for 60 days before or after the date on which one had to own the stock to qualify for the dividend (called the "ex-dividend" date). For a retail investor, the main tax-implications are:

• If you aim to limit taxable income from your stock-holdings, then in a taxable account hold mutual funds or ETFs with limited dividend-payments. In a tax-advantaged account, the dividend rate doesn't matter, as you won't be taxed separately on dividend-payments; your only taxes will occur in the future, when you take withdrawals from the account.
• Alternatively, in a taxable account, if you are willing to pay some taxes, be aware of the following priorities. Your tax-rate will be lowest on interest from municipal bonds; intermediate on qualified dividends; and highest on other interest-payments.

Short-Term Capital Losses. If you sell an asset at a loss after holding it less than a year, then on your federal tax return (and possibly in some states) you can deduct the loss from your other income. A deduction is also possible on assets sold at a loss after being held a year or longer, but there's a limit on how big a deduction you can take for long-term losses in a given year. To be tax-wise about your losses:

• When you sell mutual funds or ETFs in a taxable account, prefer transactions that meet two criteria: you have held the shares you are selling for less than a year, and you are selling them at a loss. Be sure you know the details, as explained in this IRS publication.
• Alternatively, invest your taxable account at a firm that automatically executes sales in a manner that identifies shares eligible to be treated as short-term capital losses, whenever the investment plan dictates that a sale should occur (e.g., for rebalancing or periodic withdrawals). Betterment, Wealthfront, and Schwab all offer this service on taxable accounts.
• These firms may also take the strategy one-step further and do automated tax-loss-harvesting. This method is implemented with an algorithm that actively looks for short-term losses, executes them, and immediately replaces the just-sold shares with others that are very similar but not subject to the IRS rule on "wash sales." Some might conclude that aggressive tax-loss harvesting, although presumptively legal, is on the questionable end of their personal ethical spectrum. Accordingly, the investment firm may require you to sign up for this service if you want it. They shouldn't automatically impose it on you.

Goals

Sometimes, your investment goal will be definitively long-term or short-term, not both, and indisputably taxable or not. Then the ideas listed above should suffice to guide you toward tax-wise decisions. In other cases, however, your goal may have a mixed time-horizon that spans the one-year tax boundary between long-term and short-term capital gains; an example would be a major purchase for which you save over a few years, then spend all at once. Or your goal may allow alternate placements because it's achievable in either a tax-favored account or a taxable one; an example here would be a reserve-fund for a retiree. This section examines special cases like these.

Mixed Time Horizon

Investing to Buy. When you save toward a major purchase, such as buying a home, your time-horizon is likely to be several years at the beginning. But as you get close to the date of purchase, your decisions are more short-term. The change in your time-horizon will affect the specific investments you hold, as explained in the related article, Investing to Buy. It should also affect how you manage your taxes:

• To maximize the opportunity for long-term capital gains, investments in stocks, and in funds or ETFs that hold stocks, should occur at least one year before the expected date of purchase.
• During the 12-month period immediately preceding the purchase, your investments should be concentrated in short-duration bonds that offer both safety from default and some limitation on taxes. Good candidates are a fund of short-term Treasuries, such as VGSBX from Vanguard or SHY from iShares, or a diversified mix of short-duration municipal bonds, such as VMLTX from Vanguard or SUB from iShares.

Living Expenses. Are your living expenses covered, at least partly, by post-tax savings? This might be the case, for example, if you have Required Minimum Distributions (RMD) from retirement accounts or if you received a large post-tax inheritance or a life-insurance payment. In cases like these, it may be advisable to segregate your savings into two accounts or funds:

• A long-term account or all-in-one fund would hold investments you don't expect to spend in the immediate 12 to 24 months. As a protection against long-term inflation, at least a modest portion would be invested in stocks, perhaps as outlined in our articles Basic Portfolios and How Long? If these investments were sold in the future to generate income for your living expenses, they might qualify for long-term capital gains.
• Your anticipated expenses for this year or next year would be held in funds like those listed above for Investing to Buy: short-term Treasuries, such as VGSBX from Vanguard or SHY from iShares, or a diversified mix of short-duration municipal bonds, such as VMLTX from Vanguard or SUB from iShares.

Income Reserves. If you have a reserve fund to protect against loss of income from your job, there is no definitive date when you will withdraw from the fund. Possibly, you may take withdrawals within 12 months. More likely, however, you will withdraw more than a year in the future, if ever. In any event, the fund is almost certainly in a taxable account. Should it be an accessible bank-savings or money market account? That may be the default choice for many investors, but there are reasons to view it with skepticism. The interest rate may be low compared to the current inflation rate, and taxes will likely have to be paid on the interest. Consequently, there’s a decent chance the reserve fund will lose buying power over time. The following ideas may be less exposed to taxes and inflation:

• Our Income Reserves calculator invests the fund as if most of it will be spent a few years in the future, when long-term capital gains might apply. Accordingly, there's a small but safe allocation to stocks.
• Because the account is taxable and because some of it could possibly be spent in the current year, bond investments within an income reserve fund should be held, at least partially, in short-term Treasuries or municipal bonds. As in other examples for mixed time horizons, examples of suitable funds are VGSBX and VMLTX from Vanguard, or SHY and SUB from iShares.

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Alternate Placements

Reserve Funds after Age 59½. If you are older than 59½, consider using a portion of your retirement account as your reserve fund. After that age, no tax-penalty will hit your withdrawals. The fund will grow tax-free within a retirement account and, if withdrawn when you are older, will be taxed at your then-current rate, which may be lower than your rate now. There are two scenarios:

• In one scenario, you already have a taxable reserve fund, but have passed age 59½. In this case, you could spend your taxable reserve fund for current income and either defer starting Social Security or defer taking voluntary withdrawals from your retirement fund. At the same time, you would set aside part of your retirement assets as explained in our article on reserve funds for retirees. In effect, you are spending your already-taxed reserves, replacing them with tax-favored reserves, and increasing the value of other retiree income by postponing it.
• In the second scenario, you are retired; you have an IRA, 401(k), 403(b), or 457 retirement account; and you don't have a reserve fund. In this case, your should estimate your reserve needs with our Retiree Reserves calculator, and use the article on reserve funds for retirees to allocate part of your retirement account as a reserve fund.

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Spending and Withdrawals for Retirement Income. If you are retired and some of your living expenses are paid from your investments and savings, there's a particular order of withdrawals to consider. It may generally minimize tax-consequences for most retirees. The idea is to start at the beginning of the list, go down just far enough to cover your expenses, then stop.

• First, sell investments held less than a year in a taxable account that can be sold at a loss, if you have any. These short-term losses may be taken as deductions against your other income on your federal tax return.
• Second, spend Required Minimum Distributions (RMDs) that you are taking in the current tax-year, if you have any. You must pay taxes on them anyway and should spend them before re-investing them in a manner that may generate additional taxable income. 
• Third, spend amounts deposited in a taxable account on which you get paid ordinary interest. This would include bank savings, T-Bills, money-market funds, and CDs that are maturing. In these cases, you have already paid taxes on the principal amounts. Furthermore, if you kept the funds invested as they are, they would earn interest taxed at your top rate.
• Fourth, sell investments you have held in a taxable account for more than a year, particularly if they generate qualified dividends or are being sold for a capital gain. You will have to pay some taxes if you are selling them at a gain, but the rate will almost certainly be lower than on your ordinary income. Furthermore, the original investment amount won't be taxes at all; it qualifies as a return of capital. Were you to continue holding these fourth-ranked investments, they would generate lower taxes in a given year than the items listed above as third-ranked; so it's smart to hold them longer if possible.
• Last, spend by taking voluntary withdrawals from your retirement accounts. One reason that voluntary withdrawals come last is that penalties may apply if you are younger than 59½. Another is that this income will be taxed at your top rate, so should be deferred as along as possible. Additionally, by keeping investments in a retirement account as long as possible, you maximize the time that their growth is tax-free. These considerations may be particularly valuable for the heirs or beneficiaries of your estate.

College Education Expenses. A 529 plan will cover most educational expenses for college and graduate school, including tuition; school fees; room and board; books; and computer technology, equipment, and internet access. Because of the breadth and tax-favored treatment of 529 plans, they are often the first choice for placement of college savings. However, there can be exceptions that would motivate you to save partially in a 529 plan and partially in other ways.

• If the student is enrolled outside the U.S., perhaps for a short-term program, their expenses may not be covered. Similarly, transportation may not be covered, even in the U.S., unless, for example, it is a course-requirement. Start here to review the relevant IRS policies. If you anticipate that an expense will not be reimbursable from your 529 plan, you might plan for it with supplementary savings in one of the following: short-term Treasuries, such as VGSBX from Vanguard or SHY from iShares; or a diversified mix of short-duration municipal bonds, such as VMLTX from Vanguard or SUB from iShares; or iBonds from the U.S. Treasury in a TreasuryDirect account.
• A special case may arise if you are saving new money for the current expenses of a student who is already enrolled in college or graduate school, and your state offers no tax incentive or deduction for saving in a 529 plan. In such cases, rather than pay fees of about 0.2% to a 529 vendor for simply managing cash investments, you might want to consider the options listed just above.

Advice

Because your circumstances may be unique, it’s best to review your plans and accounts with your tax adviser or with your preferred software package for tax-management. The generic ideas above may or not apply well to you. Here are some examples of questions you might pose to your adviser or test with your preferred software. (For ideas on possible sources of advice, see our article Finding Advice, on the Investing menu.)

• Should you consider converting your retirement accounts to Roth accounts? The answer is rarely simple. Among the factors affecting it are your age, tax rate, and future tax rate, plus the likely tax rates of those who may inherit your estate.
• Are tax-advantaged municipal bonds advisable for you? How much might you save, and would that amount exceed any transaction fees you might incur?
• If you need income and qualify for Social Security benefits, is it better to take them now or to postpone doing so and instead withdraw from your retirement accounts?
• How should you prioritize the options for adding new deposits to your retirement savings?
• How can you minimize the tax-consequences of spending down your investments?
• If you are considering moving to a different state, should any of your savings, investments, or spending plans be modified? Examples of possibly relevant issues are that a 529 plan in one state may or may not be convertible to another state's plan without tax-consequences, and municipal bonds may be more or less attractive as investments in your new state.

If you prefer to manage these matters yourself, or would like a second perspective to compare with your tax adviser's recommendations, we at able2pay.com think highly of ESPlanner. It's a software package that incorporates current tax-tables and policies for all states, the federal government, and Social Security. A free version is available at basic.esplanner.com, along with some good video tutorials.

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Disclaimer: Historical data cannot guarantee future results. Although a mixture of bonds, stocks, and real estate may be safer than investing exclusively in one class of assets, diversification cannot guarantee a positive return. Losses are always possible with any investment strategy. Nothing here is intended as an endorsement, offer, or solicitation for any particular investment, security, or type of insurance. Please read our Fiduciary Oath and full Disclosures.