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All investment vehicles come with a cost. Even investors who are very aware of the costs associated with various types of investments are still subject to taxes. Luckily, tax-efficient investment strategies can be used to diminish the bite that taxes take out of an investor's returns.
The percentage of expenses paid on an investment account has a big impact on the long-term returns an investor can expect to see on that investment. Taxes are often the biggest expense. However, careful asset allocation and investment selection can dramatically reduce the tax burden faced by the investor. Why do expenses have such a large impact on the long-term returns that a portfolio generates? This is because the money paid in expenses isn't available to be reinvested so it can continue to grow.
Investment accounts can all be divided into one of two categories: They are either tax-advantaged or taxable. Each category of accounts has its own pros and cons. Accounts from both categories are needed to create a tax-efficient investment strategy. One reason for this is that to minimize the taxes due as much as possible, it's necessary to place different sorts of investments into either taxable or tax-advantaged accounts.
Brokerage accounts don't have tax benefits. They are an example of a taxable account. However, unlike tax-advantaged accounts, they are far more flexible and come with fewer rules and restrictions than tax-advantaged accounts like 401(k)s or HSAs. For example, the investor can take money out of their brokerage account at any time for any reason without facing penalties. Also, not all assets held in a brokerage necessarily are subject to the highest possible tax rates. Factors like how long the asset was owned by the investor can affect what capital gains rate the proceeds will be taxed at.
There are two separate types of tax-advantaged accounts. Typically, they are either tax-exempt or tax-deferred. The difference lies mostly in the type of account and what sort of money is used to invest in it. Traditional 401(k) and 403(b) plans and IRAs are all tax-deferred accounts. The accounts are funded with pre-tax dollars, and it's usually possible to deduct the amount invested from personal taxes. Taxes are not paid on the money invested in these accounts until the money is withdrawn during the investor's retirement, when most people are in a lower tax bracket. Roth IRAs, 403(b)s, and 401(k)s are tax-exempt accounts. These accounts are funded with post-tax dollars. Since the tax has already been paid on the money invested, no tax is due on qualified withdrawals made in retirement, no matter how much the initial investment has grown.
It's important to remember that the downside of tax-advantaged accounts is that they come with restrictions. There are limits on how much money can be added to the account each year, and there are also restrictions on withdrawing money from the account. Usually, any withdrawal made before the investor has reached retirement age is subject to penalties and taxes.
Annual contribution limits on tax-advantaged accounts must be considered as part of a tax-efficient investment strategy. For IRAs, the limits were at $6,000 for those under 50 and $7,000 for those 50 and older in 2022; these limits increased by $500 for 2023. Meanwhile, 401(k)s have higher, and slightly more complicated, limits. In 2022, those under 50 could contribute up to $20,500 on their behalf, and when added to their employer's contribution, the total couldn't be more than $61,000. Those over 50 had a personal limit of $27,000 and a total amount of $67,500. The limits increased to $22,500/$66,000 for those under 50 and $30,000/$73,500 for those over 50 starting in 2023.
The most important way to work around the limits while maximizing the efficiency of the tax strategy is to make sure that investments are going into the correct accounts. Investments that are subject to higher taxes should be placed in tax-advantaged accounts, while investments with a low expected tax burden should go into taxable accounts.
Investments don't just incur a tax bill when they are sold. Some investments that distribute capital gains or dividends to those who hold the investments incur regular tax bills. Choosing tax-efficient investments will help to ensure minimal tax bills. Types of investment vehicles to consider include exchange-traded funds (ETFs) or tax-managed funds, since they rarely have capital gains. However, actively managed funds cycle through investments more quickly and therefore tend to have capital gains distributions and can create bigger tax bills for investors.
Some bonds are also more tax-efficient than others. Income generated by municipal bonds isn't subject to federal taxes and is often also exempt from local and state taxes. Since they are incredibly tax-efficient, they are a good fit for taxable brokerage accounts. Similarly, savings and treasury bonds are also exempt from local and state taxes and therefore are tax-efficient and belong in taxable accounts. However, bonds issued by corporations aren't exempt from taxes and belong in tax-advantaged accounts.
Minimizing taxes is one of the core principles of investing, and one of the best ways to do this is by using a tax-advantaged account for investments that aren't very tax-efficient while placing investments that are tax-efficient into a taxable account. Remember that there are other factors besides optimizing tax efficiency at play, too. Sometimes, it makes the most sense to put a highly taxable asset in a taxable account because the investor needs to maximize their liquidity. Each investor has different goals and needs and should invest to meet them.