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How to invest tax-efficiently

Key takeaways

  • Taxes shouldn't be the primary driver of your investment strategy—but it makes sense to take advantage of opportunities to manage, defer, and reduce taxes.
  • Manage federal income taxes by considering how capital gains and losses are recognized in your portfolio.
  • Using tax-deferred accounts when appropriate can help keep more of your money invested and working for you—and you then pay taxes on withdrawals in the future.
  • Reduce taxes further by considering strategies such as donating appreciated securities to charity and funding education expenses using a 529 plan.
  • Educate yourself on the tax implications of your employer's stock plans.

Some 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 market volatility and inflation are likely at the top of many investors' minds, better tax awareness does have the potential to improve your after-tax returns. There are several different levers to pull to try to manage federal income taxes: selecting investment products, timing of buy and sell decisions, choosing accounts, taking advantage of realized 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 federal income 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 impact 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. If there are excess losses, up to $3,000 can be claimed against taxable income in the current year, and the rest of the loss can be carried forward to offset future realized gains or income.

Capital gains: Securities held for more than 12 months before being sold are taxed as long-term gains or losses with a top federal rate of 23.8%, versus 40.8% for short-term gains (that is, 20% and 37% respectively, plus 3.8% Medicare surtax). Being conscious of holding periods is a simple way to avoid paying higher tax rates, and note that federal tax rates are subject to change. Taxes are, of course, only one consideration. It's important to consider the risk and return expectations for each investment before trading. Note: Special rules may apply to shares acquired through tax qualified equity compensation plans.

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. 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. 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.

Employer stock plans: Participation in your employer's stock plan benefit may carry nuanced, and potentially significant considerations both when selling company stock or filing taxes. (See Taxes and tax filing for more information).

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, and IRAs. If you are looking for additional tax-deferred savings, you may want to consider health savings accounts (HSAs). You may also want to consider tax-deferred annuities, which have no IRS contribution limits and are not subject to required minimum distributions (RMDs). Deferring taxes may help grow your wealth faster by keeping more of it invested and potentially growing.

You may already be familiar with tax-advantaged retirement saving accounts.

  2023 Annual contribution limits Required minimum distribution (RMD) rules Contribution treatment
Employer-sponsored plans [401(k)s, 403(b)s]
  • $22,500 per year per employee
  • If age 50 or above, $30,000 per year
Mandatory withdrawals starting in the year you turn 73* Pretax or after-tax
IRAs (Traditional1 and Roth2)
  • $6,500 per year
  • If age 50 or above, $7,500 per year
Mandatory withdrawals starting in the year you turn 73* (except for Roth)
  • Traditional IRA: Pretax or after-tax
  • Roth IRA: After-tax only***
Tax-deferred annuities No contribution limit** Not subject to required minimum distribution rules for nonqualified assets After-tax
*The change in the RMD age requirement from 72 to 73 only applies to individuals who turn 73 on or after January 1, 2023. Please consult with your tax professional regarding the impact of this change on future RMDs.
**Issuing insurance companies reserve the right to limit contributions.
***Contributions to Traditional IRAs are generally made with after-tax dollars; however, a full or partial tax-deduction is available for those under certain MAGI thresholds, which essentially converts their after-tax Traditional IRA contributions to pre-tax treatment when they file taxes. For those who earn too much to get the deduction, their Traditional IRA contributions retain the after-tax treatment. There is no tax-deduction for Roth IRAs for anyone, and therefore Roth IRA contributions are always treated as after-tax.

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-advantaged account rather than a taxable account. That approach may help to maximize the tax treatment of these accounts.

Read Viewpoints on Fidelity.com: Why asset location matters

Stock options: If you receive stock options from your employer, you may have the opportunity to manage taxes by planning ahead on your exercise strategy. One risk to timing your stock plan transactions around taxes is building up excess exposure to one company. This is called concentration, or too many eggs in one basket, so always consider all aspects of your investments, and not only the tax implications.

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, mutual funds, or cryptocurrency 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.3
  • 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. Shares acquired through an employer stock program are generally good candidates for donation if held long-term and can reduce a concentrated position.
  • 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.
  • Read Viewpoints on Fidelity.com: Strategic giving: Think beyond cash

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 professional 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.

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.2 Any evaluation of a potential Roth conversion should include input from a financial professional, along with a tax and/or estate planning attorney.

Read Viewpoints on Fidelity.com: Answers to Roth conversion questions.

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 current or future 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.

Read Viewpoints on Fidelity.com: 5 ways HSAs can fortify your retirement

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 funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

The change in the RMDs age requirement from 72 to 73 applies only to individuals who turn 72 on or after January 1, 2023. After you reach age 73, the IRS generally requires you to withdraw an RMD annually from your tax-advantaged retirement accounts (excluding Roth IRAs, and Roth accounts in employer retirement plan accounts starting in 2024). Please speak with your tax advisor regarding the impact of this change on future RMDs.

Recently enacted legislation made a number of changes to the rules regarding defined contribution, defined benefit, and/or individual retirement plans and 529 plans. Information herein may refer to or be based on certain rules in effect prior to this legislation and current rules may differ. As always, before making any decisions about your retirement planning or withdrawals, you should consult with your personal tax advisor.

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.

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.

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.

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.

Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry.

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.

1. 2022 Traditional IRA Contribution Income Limits: For a Traditional IRA, full deductibility of a contribution is available to active participants whose 2022 Modified Adjusted Gross Income (MAGI) is $109,000 or less (joint) and $68,000 or less (single); partial deductibility for MAGI up to $129,000 (joint) and $78,000 (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 $198,000 for 2022; partial deductibility for MAGI up to $208,000. 2. 2022 Roth IRA Contribution Income Limits: For single filers: For 2022, single filers with Modified Adjusted Gross Income (MAGI) up to $129,000 are eligible to make a full contribution; a partial contribution can be made for MAGI of $129,000–$144,000. For 2022, married filing jointly with MAGI up to $204,000 for a full contribution; partial contribution for MAGI of $204,000–$214,000. 3. 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). 4. Tax-smart investment management 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 investment 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.

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