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5 ways to be a tax-smart investor

Key takeaways

  • The amount you pay in taxes can make a significant difference in your long-term investment returns.
  • Consider concentrating assets that are less tax-efficient by nature in tax-advantaged accounts, and select more tax-efficient assets for taxable accounts.
  • Tax-smart investing can be complex, so consider getting help from a financial professional.

Especially when the market is experiencing volatility, it's natural to focus on the amount your investments are gaining or losing. But the amount you pay in taxes can also be a significant headwind to long-term returns. Money that isn't paid in taxes can stay invested, offering the potential for extra growth and compounding.

When those tax savings are compounded year after year, assuming market growth, they can have a significant impact on the total value of a portfolio. A study by independent research company Morningstar of pre- and after-tax investment returns from 1926 to 2021 showed that taxes may reduce portfolio returns by 2% a year on average for investors who do not account for them when making investment decisions.1

"Investors can't control what happens with their investments day-to-day," says Naveen Malwal, institutional portfolio manager for Strategic Advisers, LLC, the investment manager for many of our clients who have a managed account. "But they can proactively take steps in an effort to earn better after-tax returns."

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While investing with taxes in mind is important, it's not always easy. It can involve decisions related to the timing of the purchase or sale of stocks, the asset classes you choose, whether you hold them in tax-deferred or taxable accounts, and the order in which you draw down your assets. "Maximizing the value from tax management can take up a lot of time for investors," notes Malwal. "But this is an area where getting professional help may lead to tangible results."

A tax-smart portfolio begins with the right asset mix for your time horizon and risk tolerance, Malwal explains, with techniques layered on that are designed to help mitigate your tax bill. Below are 5 strategies to consider.

1. Find the right location. Some assets, often those that regularly produce interest, dividends or distributions subject to capital gains taxes, are by nature less tax-efficient than others. Some examples may include:

  • Bonds and bond funds: Except for municipal bonds and some savings bonds, these assets generate interest income that is taxed at your ordinary income tax rate.
  • Real estate investment trusts (REITs): Like bonds, these assets generate income and dividends taxed at your ordinary income tax rate.
  • Actively managed stock funds: Active fund managers who buy and sell frequently may generate both short- and long-term gains for their shareholders.

Investors may want to concentrate less tax-efficient holdings in tax-deferred accounts such as a traditional IRA or 401(k), which allow you to withdraw the money post-retirement when you may be in a lower tax bracket, or tax-exempt accounts like a Roth IRA or Roth 401(k), which allow tax-free withdrawals of contributions at any time, and earnings in retirement if distributions are qualified.2

2. Consider adding tax-efficient assets. For taxable brokerage accounts, you can consider adding assets that generate little or no taxable income, if they suit your overall investment strategy:

  • Municipal bonds or ETFs. Munis are typically exempt from federal taxes and sometimes state taxes as well.
  • Passively managed index funds and ETFs. Since these funds trade infrequently, they may generate less taxable income than actively managed funds.
  • Tax-efficient active mutual funds. Some fund managers tend to trade less frequently as part of their investing approach, so these funds may be more tax-efficient than many of their peers.

3. Manage capital gains. Hanging onto securities for at least a year offers investors rewards from a tax standpoint. Gains on investments held for a year or less are taxed at your Federal ordinary income rate, which can go as high as 37%. But anything held for over a year is taxed at the lower federal long-term capital gains rate (up to 20%, depending on your taxable income). For high income earners, either short- or long-term gains may be subject to the additional 3.8% Net Investment Income Tax, and state and local taxes may also apply. When selling investments in professionally managed accounts with tax-smart investing techniques,2 the managed solutions team looks for positions that clients have held for a longer time period, allowing them to take advantage of those lower long-term rates, says Malwal.

4. Choose withdrawals carefully. If you want or need to withdraw from a taxable account, consider how it may impact both the investment mix as well as your tax bill, since securities with a low cost basis will incur higher realized capital gains when sold. If you have retirement accounts, consider rebalancing your portfolio in those accounts following withdrawals, since you won't incur capital gains on trades within tax-advantaged accounts. Consult a tax advisor to determine the withdrawal strategy that works for you.

5. Harvest losses. Market volatility can offer an opportunity to reduce taxes on realized capital gains. Net capital losses can be used to net out taxable gains, and remaining capital losses can be used to offset $3,000 of taxable income per year for an individual or married couple filing jointly ($1,500 for married, filing separately). In addition, any unused losses can be carried forward for the life of the investor. "Tax-loss harvesting can be particularly effective if an investor looks for opportunities year-round as markets experience inevitable periods of volatility," says Malwal. "Investors who wait until the end of the year or each quarter will often miss out on opportunities that may have come earlier in the year." Tax-loss harvesting can be tricky, cautions Malwal; you need to be careful of wash-sale rules, which can disallow the write-off. Consider consulting with a tax advisor or financial professional.

Taxes can be a drag on your long-term investment performance, but with careful planning, it is possible to improve the tax efficiency of your portfolio. However, some of these strategies are complex and very time-consuming. A tax advisor or financial professional can help you identify the best approach for your specific situation.

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1. “Taxes Can Significantly Reduce Returns data,” Morningstar, Inc., 2022. This example reflects a 96-year period from 1926 to 2021 and is based on the following data: stocks at 10.5%, stocks after taxes at 8.5%; bonds at 5.5%, and bonds after taxes at 3.5%. Past performance is no guarantee of future results. Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $120,000 in 2015 dollars every year. For additional details on the study, please see Endnote 3 in Tax-Smart Investing: Could Ben Franklin have been Wrong? (PDF).

2. For a distribution to be considered qualified, the 5-year aging requirement has to be satisfied, and you must be age 59½ or older or meet one of several exemptions (disability, qualified first-time home purchase, or death among them). 3. Tax-smart (i.e., tax-sensitive) investing techniques, including tax-loss harvesting, are applied in managing certain taxable accounts on a limited basis, at the discretion of the portfolio manager, primarily with respect to determining when assets in a client's account should be bought or sold. Assets contributed may be sold for a taxable gain or loss at any time. There are no guarantees as to the effectiveness of the tax-smart investing techniques applied in serving to reduce or minimize a client's overall tax liabilities, or as to the tax results that may be generated by a given transaction.

Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

The municipal market can be affected by adverse tax, legislative, or political changes, and by the financial condition of the issuers of municipal securities.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Optional investment management services provided for a fee through Fidelity Personal and Workplace Advisors LLC (FPWA), a registered investment adviser and a Fidelity Investments company. Discretionary portfolio management provided by its affiliate, Strategic Advisers LLC, a registered investment adviser. These services are provided for a fee.

Brokerage services provided by Fidelity Brokerage Services LLC (FBS), and custodial and related services provided by National Financial Services LLC (NFS), each a member NYSE and SIPC. FPWA, Strategic Advisers, FBS, and NFS are Fidelity Investments companies.

Investing involves risk, including risk of loss.

Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917

This information is intended to be educational and is not tailored to the investment needs of any specific investor.

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