How to invest tax-efficiently

Create a strategy to help manage, defer, and reduce taxes.

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Key takeaways

  • While an investment strategy shouldn’t be based solely on taxes, it should still consider any opportunities to manage, defer, and reduce taxes.
  • Manage taxes by considering the role of losses, the timing of investments, and investment selection.
  • Defer taxes by considering the use of tax-deferred accounts.
  • Reduce taxes by considering strategies like donating appreciated securities to charity, and funding education expenses using a 529 plan.

Investors spend untold hours researching stocks, bonds, and mutual funds with good return prospects. They read articles, watch investment shows, and ask friends for help and advice. But many of these investors could be overlooking another way to potentially add to their returns: tax efficiency.

Investing tax-efficiently doesn't have to be complicated, but it does take some planning. While taxes should never be the sole driver of an investment strategy, better tax awareness does have the potential to improve your returns. Morningstar estimates investors gave up an average of 1% to 2% of return per year to taxes for the 90 years through 2016. Let's say a portfolio could earn 8% per year instead of 6%, that extra return of 2% per year on a hypothetical portfolio of $100,000 could result in an additional $1 million after 40 years.1 This could be one of the best investment decisions you make this year, or any other year. Here are some tips.

There are several different levers to pull to try to manage taxes: selecting investment products, timing of buy and sell decisions, choosing accounts, taking advantage of losses, and specific strategies such as charitable giving can all be pulled together into a cohesive approach that can help you manage, defer, and reduce taxes.

Of course, investment decisions should be driven primarily by your goals, financial situation, timeline, and risk tolerance. But as part of that framework, factoring in taxes may help you build wealth faster.

Manage your taxes

The decisions you make about when to buy and sell investments, and about the specific investments you choose, can help to determine your tax burden. While tax considerations shouldn't drive your investment strategy, consider incorporating these concepts into your ongoing portfolio management process.

Tax losses: A loss on the sale of a security can be used to offset any realized investment gains, and then up to $3,000 in taxable income annually. Some tax-loss-harvesting strategies try to take advantage of losses for their tax benefits when rebalancing the portfolio, but be sure to comply with Internal Revenue Service (IRS) rules on the tax treatment of gains and losses.

Loss carryforwards: In some cases, if your losses exceed the limits for deductions in the year they occur, the tax losses can be "carried forward" to offset investment gains in future years.

Capital gains: Securities held for more than 12 months are taxed as long-term gains or losses with a top federal rate of 23.8% (versus 40.8% for short-term gains). Being conscious of holding periods is a simple way to avoid paying higher tax rates.

Fund distributions: Mutual funds distribute earnings from interest, dividends, and capital gains every year. Shareholders are likely to incur a tax liability if they own the fund on the date of record for the distribution in a taxable account, regardless of how long they have held the fund. Therefore, mutual fund investors considering buying or selling a fund may want to consider the date of the distribution.

Tax-exempt securities: Tax treatment for different types of investments varies. For example, municipal bonds are typically exempt from federal taxes, and in some cases receive preferential state tax treatment. On the other end of the spectrum, real estate investment trusts and bond interest are taxed as ordinary income—with rates up to 37% for the top income tax bracket in 2018. Sometimes, municipal bonds can improve after-tax returns relative to traditional bonds. Investors may also want to consider the role of qualified dividends as they weigh their investment options. Like long-term capital gains, qualified dividends are taxed at a top rate of 23.8%. Qualified dividends are subject to the same tax rates as long-term capital gains, which are lower than rates for ordinary income.

Fund or ETF selection: Mutual funds and exchange-traded funds (ETFs) vary in terms of tax efficiency. In general, passive funds tend to create fewer taxes than active funds. While most mutual funds are actively managed, most ETFs are passive, and index mutual funds are passively managed. What's more, there can be significant variation in terms of tax efficiency within these categories. So, consider the tax profile of a fund before investing.

Defer taxes

Among the biggest tax benefits available to most investors is the ability to defer taxes offered by retirement savings accounts, such as 401(k)s, 403(b)s, IRAs, and tax-deferred annuities. By deferring taxes, you have the opportunity to grow your wealth faster.

Traditional accounts: Traditional retirement accounts can offer a potential double dose of tax advantages—contributions you make may reduce your current taxable income (if income eligibility requirements are met), and any investment growth is tax-deferred. After age 70½, however, there are minimum required distributions (MRMDs).2

Roth IRA accounts: With a Roth IRA or a Roth 401(k), you contribute after-tax dollars, but investment gains are tax-deferred, and withdrawals in retirement are tax-free, provided some conditions are met. Roths have no MRDs during the lifetime of the original owner so they can also be useful vehicles for estate planning.3

Tax-deferred annuity: Most tax-advantaged accounts have strict annual contribution limits and minimum required distribution rules. If you are looking for additional tax-deferred savings, you may want to consider tax-deferred annuities, which have no IRS contribution limits and are not subject to MRDs.

  2019 Annual contribution limits Minimum required distribution (MRD) rules Contribution treatment
Employer-sponsored plans
[401(k)s, 403(b)s]
  • $19,000 per year per employee
  • If age 50 or above, $25,000 per year
Mandatory withdrawals starting in the year you turn 70½ Pretax or after-tax
(Traditional2 and Roth3)
  • $6,000 per year
  • If age 50 or above, $7,000 per year
Mandatory withdrawals starting in the year you turn 70 1/2 (except for Roth) Pretax or after-tax
Tax-deferred annuities
No contribution limit* Not subject to minimum required distribution rules for nonqualified assets After-tax
*Issuing insurance companies reserve the right to limit contributions.

Account selection: When you review the tax impact of your investments, consider locating and holding investments that generate certain types of taxable distributions within a tax-deferred account rather than a taxable account. That approach may help to maximize the tax treatment of these accounts.

Reduce taxes

Charitable giving
The United States tax code provides incentives for charitable gifts—if you itemize taxes, you can deduct the value of your gift from your taxable income (limits apply). These tax-aware strategies can help you maximize giving:

  • Contribute appreciated stock instead of cash: By donating long-term appreciated stocks or mutual funds to a public charity, you are generally entitled to a fair market value (FMV) deduction, and you may even be able to eliminate capital gains taxes. Together, that may enable you to donate up to 23.8% more than if you had to pay capital gains taxes. 4
  • Contribute real estate or privately held business interests (e.g., C-corp and S-corp shares; LLC and LP interests): Donating a non-publicly traded asset with unrealized long-term capital gains also gives you the opportunity to take an income-tax charitable deduction and eliminate capital gains taxes.
  • Accelerate your charitable giving in a high-income year with a donor-advised fund: You can offset the high tax rates of a high-income year by making charitable donations to a donor advised fund. If you plan on giving to charity for years to come, consider contributing multiple years of your charitable contributions in the high-income year. By doing so, you maximize your tax deduction when your income is high, and will then have money set aside to continue supporting charities for future years.

Roth conversions

Instead of deferring taxes, you may want to accelerate them by using a Roth account, if eligible—either a Roth IRA contribution or a Roth conversion.3 A Roth IRA contribution won’t reduce your taxable income the year you make it; in fact you will have to pay taxes on any tax-deferred deposits and investment gains at the time of the conversion. But there are no taxes on your future earnings and no penalties when you take a distribution, provided you hold the account for 5 years and meet one of the following conditions: you are age 59½ or older, are disabled, make a qualified first-time home purchase (lifetime limit $10,000), or have died. Also, be aware that while your earnings may be subject to taxes and penalties if withdrawn before those conditions are met, your contributions can be withdrawn at any time without tax or penalty.

529 savings plans

The cost of education for a child may be one of your biggest single expenses. Like retirement, there are no shortcuts when it comes to saving, but there are some options that can help your money grow tax-efficiently. For instance, 529 accounts will allow you to save after-tax money, but get tax-deferred growth potential and federal income tax-free withdrawals when used for qualified expenses including college and, since 2018, also up to $10,000 per student per year in qualified K–12 tuition costs.

Health savings accounts (HSAs)

Health savings accounts allow you to save for health expenses in retirement. These accounts have the potential for a triple tax benefit—you may be able to deduct current contributions from your taxable income, your savings can grow tax-deferred, and you may be able to withdraw your savings tax-free, if you use the money for qualified medical expenses.

The bottom line

Your financial strategy involves a lot more than just taxes, but by being strategic about the potential opportunities to manage, defer, and reduce taxes, you could potentially improve your bottom line.

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Before investing, consider the investment objectives, risks, charges, and expenses of the fund or annuity and its investment options. Call or write to Fidelity or visit for a free prospectus or, if available, summary prospectus containing this information. Read it carefully.

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

Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.

Each Income Replacement Fund's investment objective is intended to support a payment strategy through the Smart Payment Program (SPP). Monthly payments may not keep pace with inflation, will fluctuate year over year, and will result in the gradual liquidation of an investment in the fund by its horizon date. As with any mutual fund, withdrawals will reduce the investment balance, and future returns are not earned on amounts withdrawn. The funds and the SPP may not be appropriate for all investors. Please consult the fund's prospectus for more details.

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. Lower-quality fixed income securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Foreign investments involve greater risks than U.S. investments, and can decline significantly in response to adverse issuer, political, regulatory, market, and economic risks. Any fixed-income security sold or redeemed prior to maturity may be subject to loss.

The municipal market can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Although state-specific municipal funds seek to provide interest dividends exempt from both federal and state income taxes and some of these funds may seek to generate income that is also exempt from federal alternative minimum tax, outcomes cannot be guaranteed, and the funds may generate some income subject to these taxes. Residency in the state is usually required for the state income tax exemption. Generally, municipal securities are not appropriate for tax advantaged accounts such as IRAs and 401(k)s.

Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.

Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.

Past performance is no guarantee of future results.

This data is for illustrative purposes only and does not represent actual or future performance of any investment option. Returns include the reinvestment of dividends and other earnings. Stocks are represented by the Ibbotson® Large Company Stock Index. Government bonds are represented by the 20-year US government bond, cash by the 30-day US Treasury bill, and inflation by the Consumer Price Index. The data assumes reinvestment of income and does not account for transaction costs. An investment cannot be made directly in an index.

Tax-sensitive investment management techniques (including tax-loss harvesting) are applied 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. With this discretionary investment management service, any assets contributed to an investor’s account that the portfolio manager does not elect to retain may be sold at any time after contribution. An investor may have a gain or loss when assets are sold.

1. Taxes Can Significantly Reduce Returns data: Morningstar, Inc., 10/1/2017. 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. This annual income is adjusted using the Consumer Price Index in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs. When realized, capital gains are calculated assuming the appropriate capital gains rates. The holding period for capital gains tax calculation is assumed to be 5 years for stocks, while government bonds are held until replaced in the index. No state income taxes are included. Stock values fluctuate in response to the activities of individual companies and general market and economic conditions. Generally, among asset classes, stocks are more volatile than bonds or short-term instruments. Government bonds and corporate bonds have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. U.S. Treasury bills maintain a stable value if held to maturity, but returns are generally only slightly above the inflation rate. Although bonds generally present less short-term risk and volatility than stocks, bonds do entail interest rate risk (as interest rates rise, bond prices usually fall, and vice versa), issuer credit risk, and the risk of default, or the risk that an issuer will be unable to make income or principal payments. The effect of interest rate changes is usually more pronounced for longer-term securities. Additionally, bonds and short-term investments entail greater inflation risk, or the risk that the return of an investment will not keep up with increases in the prices of goods and services, than stocks.
2. 2018 Traditional IRA Contribution Income Limits: For a Traditional IRA, full deductibility of a contribution is available to active participants whose 2018 Modified Adjusted Gross Income (MAGI) is $101,000 or less (joint) and $63,000 or less (single); partial deductibility for MAGI up to $121,000 (joint) and $73,000 (single). In addition, full deductibility of a contribution is available for working or nonworking spouses who are not covered by an employer-sponsored plan and whose spouse is covered by an employer-sponsored plan and whose MAGI is less than $189,000 for 2018; partial deductibility for MAGI up to $199,000.
3. 2018 Roth IRA Contribution Income Limits: For single filers: For 2018, single filers with Modified Adjusted Gross Income (MAGI) up to $120,000 are eligible to make a full contribution; a partial contribution can be made for MAGI of $120,000–$135,000. For 2018, married filing jointly with MAGI up to $189,000 for a full contribution; partial contribution for MAGI of $189,000–$199,000.
4. This assumes that all realized gains are subject to the maximum federal long-term capital gains tax rate of 23.8% (includes the 3.8% Medicare surtax).
5. The chart assumes that the donor is in the 37% federal income bracket. State and local taxes and the federal alternative minimum tax are not taken into account. Please consult your tax advisor regarding your specific legal and tax situation. Information herein is not legal or tax advice. Assumes all realized gains are subject to the maximum federal long-term capital gains tax rate of 20% and the Medicare surtax of 3.8%. Does not take into account state or local taxes, if any.
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