How to invest tax efficiently

Find ways to help create a strategy that defers, manages, and reduces taxes.

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You may know your federal income tax bracket. But that's not really what you pay. In fact, the middle 20% of Americans by income pay about 13% of income in federal income taxes. But that average hides a great deal of variation: Some Americans pay nothing, and others pay more than 30%.1

What determines the percentage you will pay? A lot of it is based on how much you make. But you can affect your tax bill by knowing the rules, managing how you generate income, choosing what accounts you invest in, and taking advantage of potential deductions. In general, there are three strategies you can use to try to manage your federal income taxes:

  • Defer taxes with tax-advantaged accounts or investing strategies, such as 401(k)s, 403(b)s, IRAs, health savings accounts (HSAs), and products such as deferred annuities.
  • Manage your tax burden by employing strategic asset location, investing in lower turnover funds, understanding mutual fund distributions, and taking advantage of charitable gifts and capital loss deductions.
  • Reduce taxes now with federal income tax free municipal bond income, or reduce taxes in the future with a Roth IRA or 529 college savings account.

“We all make decisions about how we save, invest, and earn income,” says Ken Hevert, senior vice president at Fidelity. “By considering the tax impact of those decisions, and adjusting your investment strategy with elements that make sense for your own circumstances and goals, you may be able to create a better financial outcome.”

Here are a few educational ideas that can help you enhance your investing strategy. These general ideas are not advice but could help you begin to construct a tax strategy.


Defer taxes.

Saving for retirement is a big job. Accounts that offer tax advantages can help and can be a key part of an overall tax strategy because they allow you to put off paying taxes. For savers, the key is to maximize the potential tax benefits of these accounts, if you and your adviser decide that attempting to defer taxes makes sense for you.

tax-deffered Take advantage of retirement accounts.

Among the biggest tax benefits available to most investors are the benefits offered by retirement savings accounts such as 401(k)s, 403(b)s, and IRAs. Traditional 401(k)s, IRAs, and other accounts can offer a double dose of tax advantages—the contributions you make may reduce your current taxable income, saving you cash this year, and any investment growth is tax deferred, saving you money while you are invested. In the case of HSAs, accounts that are used with high-deductible health care insurance plans, withdrawals used for qualified medical expenses could be triple tax free: tax-free contributions, earnings, and withdrawals.

"The tax advantages of these accounts are one reason we think a top financial priority for most investors should be to take advantage of 401(k)s, HSAs and other workplace saving plans, or IRAs," says Hevert.

Generally, the first step to tax-advantaged savings should be through workplace savings plans, IRAs, or both. But those accounts have strict annual contribution limit rules. If you are looking for additional tax-deferred savings, you may want to consider deferred variable annuities, which have no IRS contribution limits.

Read Viewpoints: The three A’s of successful saving


Manage taxes.

Taking advantage of tax-deferred accounts is a key step in building a tax strategy, but it’s only part of the story. You may have more opportunities for tax efficiency by being strategic about the accounts you use to hold the investments that generate the most taxes, choosing investments that may create less of a tax burden, and taking advantage of tax deductions to reduce your overall bill.

When considering taxes and investment selection, it is important to remember that old adage: Don’t let the tail wag the dog. That’s because taxes are an important factor in an investing strategy, but they certainly aren’t the only factor. The potential tax benefits of any strategy need to be viewed in the context of your overall investing plan. That said, there are some choices that can have a potential impact on your tax bill.

tax-sensitive Match the right account with the right investment.

An asset location strategy may sound complex, and it can be, but the basic idea is straightforward: Put the investments that may generate the most taxable income in accounts that provide tax advantages. Tax-efficient assets, like municipal bonds, stock index ETFs, or growth stocks you hold for the long term, may generate relatively small tax bills and may make more sense in a taxable account.

On the other hand, relatively tax-inefficient assets such as taxable bonds, high-turnover stock mutual funds, or real estate investment trusts (REITs) may be better kept in tax-advantaged accounts like 401(k)s, IRAs, and tax-deferred variable annuities. Of course, you also need to consider your overall asset allocation, the account rules, the potential tax implications of making changes, your investment horizon, and other factors before making any changes.

Read Viewpoints: Why asset location matters

tax-sensitive Consider investments that generate less taxes.

For taxable accounts, you want to factor in the potential tax implications of your investments. Passively managed ETFs and index funds have major tax advantages compared with actively managed mutual funds. Actively managed mutual funds typically make more capital gains distributions than passive funds because of more frequent trading.3 Moreover, in most cases, capital gains tax on an ETF is incurred only upon the sale of the ETF by the investor, whereas actively managed mutual funds pass on taxable gains to investors throughout the life of the investment.

Beyond choosing between ETFs, index funds, or actively managed funds, consider a tax-managed mutual fund or separately managed account. These investments try to take advantage of tax lots and purchase dates, gains, and losses to manage the tax exposure of the portfolio. In some cases, managed accounts may be personalized to certain aspects of your tax situation.

tax-sensitive Keep an eye on the calendar.

Like comedy, a good tax strategy requires timing. For instance, if you are considering investing in a mutual fund for your taxable accounts, you may want to consider the distributions history of that fund. Mutual funds are required to distribute at least 90% of net investment income and 98% of net capital gains income every year, and investors are likely to incur a tax liability on the distribution. It doesn’t matter whether you have owned the fund for a year or a day, if you own it when it makes a distribution, you are obligated to pay taxes. To avoid this potential tax liability, pay close attention to the distribution schedules for any funds you own—and if you have the flexibility to do so, you may want to avoid purchasing fund shares just before the distribution date.

If you are thinking of selling a fund just before the distribution, you may want to reconsider. The downside of selling funds in an attempt to avoid a distribution is that depending on how much you paid for your shares, you could generate a significant capital gain—and the tax bill to go with it. So you need to factor in the potential tax impact of your decision against other criteria, including your asset allocation strategy and market outlook.

You also need to be aware of how long you hold an investment. If you sell a fund or security within one year of buying it, any gain could be subject to short-term capital gains rates, currently as high as 39.6% at the federal level—and some high earners may be subject to the 3.8% Medicare surtax as well. You can qualify for a lower rate on gains by holding assets for more than a year—the highest federal rate for long-term capital gains is 20%, plus an additional 3.8% if you are subject to the Medicare surtax. (Note: this discussion does not reflect state taxes).

tax-sensitive Offset gains and income with losses.

Tax-loss harvesting is when you sell an investment in a capital asset like a stock or bond for a loss and use that loss to offset realized capital gains from other securities or other income. While you shouldn't let tax decisions drive your investing strategy, tax-loss harvesting can be a powerful way to help you keep more of what you earn. Each taxpayer is allowed to use capital losses to offset capital gains, and can use any remaining losses to offset up to $3,000 of ordinary income each year. Any losses not used in a given tax year can be carried forward and used in future years. So selling losing investments and using those losses to offset gains can be used to reduce your tax bill. The strategy is typically most effective during volatile markets, especially during downturns.

Tax-loss harvesting may feel counterintuitive, because the goal of investing is to make money, not to lose it. But everyone experiences investment losses from time to time, and if handled properly and consistently, this strategy can potentially improve overall after-tax returns. The challenge is that a systematic tax-loss harvesting strategy requires disciplined trading, diligent investment tracking, and detailed tax accounting.

Read Viewpoints: Five steps to help manage taxes on investment gains

charitable Think about charitable gifts.

Giving to charity may not be the path to greater material wealth, but the use of charitable deductions can be a powerful part of a tax strategy for those who were planning to make donations. This can help with all kinds of tax strategies, from offsetting Roth IRA conversions to complex strategies such as charitable lead or charitable remainder trusts.

One way to make the most of charitable giving is to donate securities that have increased in value. You may donate the securities directly or use a donor-advised fund—these funds let you take an immediate tax deduction and then give you the opportunity to make grants to different charities later. Donating appreciated securities lets you avoid paying capital gains tax or the Medicare surtax, allowing you to donate more to charity compared with selling the stock and then donating the proceeds.

Many investors with stocks that have significant gains are worried about the capital gains tax bill they may see down the road. If those investors are planning to make charitable contributions, donating securities with significant capital appreciation to charity may help them reduce their capital gains tax.

Let’s look at a hypothetical example to see how. Karen has $10,000 she wants to donate to charity. She also has a few hundred shares of stock that have grown in value from $1,000 to $10,000 since she bought them. She wants to make a donation and own the stock, and is looking to maximize the tax value of her donation. Here are two options:

She could donate $10,000 in cash and deduct $10,000 from her current income.

Or, she could donate $10,000 of her long-term appreciated stock (in general, the fair market value of long-term stock donations to public charities are limited to 30% of adjusted gross income). The charity doesn’t pay taxes on the sale of the stock, so they still get a donation worth $10,000. Karen still gets the $10,000 income deduction. Now Karen can use the $10,000 of cash she would have used for her donation to buy back the shares at a higher price than her original purchase. For example, say she sells the stock two years later for $12,000. Her basis would be $10,000, meaning she will pay capital gains taxes on $2,000 worth of gains. If she hadn’t donated the stock, her basis would have been $1,000—meaning she would pay taxes on $11,000 worth of gains. By donating and repurchasing, she was able to lower her tax bill.

Read Viewpoints: Strategies for charitable giving


Reduce taxes.

While selecting tax-efficient investments and making the most of tax-deferred accounts may help reduce your tax bill, it won’t eliminate taxes altogether. There are a few options available that do have the potential to generate income or earnings that you generally won’t have to pay federal income taxes on—including many municipal bonds, Roth IRAs, and college savings accounts.

municipal_bond Research tax-exempt municipal bonds.

With many muni bonds, whether you’re purchasing individual securities directly or through a fund, ETF, or separately managed account, you generally get income that’s exempt from federal taxes. What’s more, in many states, if you hold bonds issued by your state of residence, these bonds offer state tax–exempt income, too. That covers most municipal bonds but doesn’t apply to all: certain municipal bonds, called private activity bonds, when held by investors subject to the alternative minimum tax.

When considering munis, it is important to note that the yield is typically lower than taxable bonds with similar credit ratings and maturity. A lower yield means they will have a higher duration, all else being equal, and a higher duration means the bond may be more volatile as rates change. (For more on duration, read the Learning Center: Duration). It also means that your tax bracket is a key factor to consider when evaluating a muni bond, along with traditional bond characteristics such as yield, maturity, and credit quality. The basic rule of thumb is that investors in higher tax brackets will be more likely to benefit from investing in munis.

roth Consider a Roth or Roth IRA conversion.

Instead of deferring taxes, you may want to accelerate them by using a Roth account. A Roth IRA or Roth 401(k) contribution won’t reduce your taxable income the year you make it, but there are no taxes on any future earnings as long as you hold the account for five years and are age 59½ or older, disabled, deceased, or withdraw earnings to pay for qualified first-time homebuyer expenses. That can make a big difference if you think your tax rate will be the same or higher than your current rate when you withdraw your money. There are also no required minimum distributions (RMDs) from a Roth IRA during the lifetime of the original owner.

Roth IRA contributions are only allowed for investors up to a certain income level, but those rules don’t apply to Roth 401(k)s, if your employer offers you one. Higher wage earners can also access a Roth through a conversion from a traditional IRA or 401(k). You pay federal income taxes now on the conversion amount but none on any future earnings—if you meet the requirements.

Read Viewpoints: 9 reasons to consider a Roth

tax-deffered Seek tax advantages for college.

The cost of higher education for a child may be one of your biggest expenses. Like retirement, there are no shortcuts when it comes to saving, but there are some options that can reduce your taxes. For instance, 529 college saving accounts and Coverdell accounts will allow you to save after-tax money but get tax-deferred growth and tax-free withdrawals when used for qualified education expenses. Grandparents can also make significant gifts to a 529 without incurring gift taxes. You may also want to consider EE savings bonds issued by the U.S. Treasury or prepaid tuition plans, which offer other tax advantages when saving for college for certain investors.

Read Viewpoints: The ABCs of college savings plans

Put a strategy into place.

There are lots of tax moves an investor can make. The key is to pull together a number of different strategies that make sense for your situation. Then be disciplined about sticking with your approach—either on your own, with a financial adviser, with a tax adviser, or with a professional money manager. Some people don’t want to spend any more time thinking about taxes than is absolutely necessary, but spending a little time assessing your situation and your options may help you keep a bit more of your money in your pocket.

Learn more.

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Donating appreciated securities to charity: This is a hypothetical example for illustrative purposes only. State and local taxes, the federal alternative minimum tax and limitations to itemized deductions applicable to taxpayers in higher income brackets are not taken into account. Please consult your tax adviser 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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1. “How Much Do Americans Pay in Federal Taxes?” Peter G. Peterson Foundation, April 14, 2014.
2. The taxable account does not reflect tax-savings strategies such as tax-loss carryforwards, earnings consisting mostly of unrealized gains each year, or other strategies that might be used to reduce taxes in a taxable account, which could make the ending value of the taxable account more favorable.
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