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.
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:
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:
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 First, after money is contributed to a 529 account, it grows tax-free; no additional taxes are paid when money is withdrawn, provided it is used for a qualified educational purpose.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:
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:
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. |
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:
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:
|
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:
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, these tax-implications apply:
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:
|
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:
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:
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 consider other options, too. The interest rate on bank deposits and money-market funds may be low compared to the current inflation rate, and taxes will likely have to be paid on the interest. Consequently, your reserve fund could lose buying power over time. The following ideas may be less exposed to taxes and inflation:
|
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:
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.
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.
|
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. Below 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 might move 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.
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.