Tax Update: The import of tax-efficient investing
- February 1, 2023: Vol. 10, Number 2

Tax Update: The import of tax-efficient investing

by Schwab Center for Financial Research

Making tax-efficiency part of your investing strategy can help lower your tax bill, and yet taxes are such a normal part of life that people may overlook them until it’s time to file their returns. Unfortunately, by that point it, may be too late to implement an efficient investment strategy for minimizing their tax bill.

The amount lost to taxes is one of the key factors affecting investor returns, just behind proper investment selection and asset allocation. Even small amounts can quickly add up to substantial sums over the years, so anything an investor can do to reduce the drag will help.

The good news is that one can exercise a good deal of control. With a bit of planning, one can make their portfolio more tax-efficient and hold onto a greater share of returns.

A big part of tax efficiency is putting the right investment in the right account. Investment accounts can be divided into two main categories:

  • Taxable accounts,such as brokerage accounts, are good candidates for investments that tend to lose less of their returns to taxes.
  • Tax-advantaged accounts, such as an IRA, 401(k) or Roth IRA, are generally a better home for investments that lose moreof their returns to taxes.

What does that mean in practical terms? On the accompanying tax table some of the most common kinds of investments are matched with taxable or tax-advantaged accounts.

Of course, this presumes the investor holds investments in both types of accounts. If all of one’s investment dollars sits in a 401(k) or IRA, then just focus on picking appropriate investments and allocating to them according to the portfolio’s goals or objectives, as well as taking into account risk tolerance and timeframe.

Holding investments in the most tax-appropriate type of account can complement savings plans by helping to reduce taxes (or, in the case of a Roth, eliminate entirely the taxes on investment returns). Spreading your investments across accounts with different tax treatments can also give more flexibility in managing taxes when starting to draw from savings in retirement. Call it “tax diversification.”

Diversifying by tax treatment can be especially important if the investor is uncertain about the future tax bracket they will end up in down the road. For example, by investing in a taxable brokerage account, and then splitting retirement-savings contributions between a tax-deferred IRA or 401(k) and an after-tax Roth account, an investor would have more options for managing income in retirement, regardless of tax bracket.

So, if the goal is to minimize the overall tax burden, one could focus on taking tax-free municipal bond income, qualified dividends and long-term capital gains (which currently tend to be taxed at lower rates) from taxable accounts and tax-free income from Roth accounts. Then the investor could take only enough money from the taxable IRA or 401(k) to cover spending needs or satisfy required minimum distributions, if applicable.

If you want to keep more of your income, managing your investments with tax efficiency in mind is a must. What’s more, tax efficient investing techniques are accessible to almost everyone — it just takes some planning to reap the benefits.


This article was excerpted from the Schwab Center for Financial Research. Read the complete report here.



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