Investing Tax Efficiently

By Jenn Moss, CFP®, CPA

There are many investment strategies that offer ways to grow your income and wealth over a long period. Between stocks, bonds, real estate, and countless other investment choices, portfolios can be created that are tailored to specific preferences and goals. At the same time, these options are all united by one common thread: at one point or another, these investments will likely become a source of income, and therefore subject to Uncle Sam’s tax code.

Benjamin Franklin famously pointed out that life’s only certainties were death and taxes, and while this still holds true, today’s tax code does offer some nuance in how various investments are taxed. Knowing this, factoring taxes into an overall investment strategy has some importance. Let’s examine some methods for ensuring that our investment choices are “tax-efficient”.

What Makes an Investment “Tax Efficient”?

The tax efficiency of your investment, quite simply, is determined by the percent of your original investment that remains after taxes are paid. This tax-efficiency is based on factors like whether it creates income (such as interest, long-term gains distributions, or dividends), the time horizon of taxation (is it taxed now, or down the road?), and whether the investment vehicle is taxed at a preferential rate, or a rate that is lower than your regular income rate.

Taxable, Tax-Deferred, and Tax-Exempt: Taxation as a Time Horizon

Before we begin, a quick disclaimer: tax laws are subject to change at any time, all discussion of tax rules and regulations mentioned here are under current tax law.

The most commonly understood nuance of tax rules for investments comes about based on when the assets are taxed. The tax code structures investment accounts as either taxable, tax-deferred, or tax-exempt:

  • Tax-Deferred Accounts: As the name implies, investors only pay taxes on earnings when they are withdrawn from the account. Investment earnings are thus “tax-sheltered” while they compound in your account, and are only subject to tax upon withdrawal. Common tax-deferred accounts include 401(k)s and IRAs.
  • Tax-Exempt Accounts: Annual interest earned on these accounts is free from federal income tax. Common tax-exempt accounts include 529 Accounts (when withdrawn for qualified higher education), Health Savings Accounts, and Roth IRAs.
  • Taxable Accounts: Investors pay taxes on the income they receive from their account in the year in which it was earned. Common taxable accounts include individual and joint investment accounts, savings accounts, and CDs.

Tax-Deferred Accounts: Popular and Efficient Portfolio Building Blocks

In discussing tax-deferred accounts, it’s probably time I bring up an important factor at play here: your adjusted gross income, or AGI. Because your AGI is the basis of your federal income tax level, a lot of focus is put toward reducing it, and one of the best ways is through contributions to tax-deferred accounts like 401(k)s and Traditional IRAs. Wherever possible, contribute the maximum amounts allowed into your 401(k) and IRA accounts each year. Your contributions reduce your taxable wages dollar for dollar which in turn reduces your overall tax burden.

When you do eventually begin making withdrawals from your retirement accounts, it will be somewhere between the ages of 59 ½ (the earliest you can be eligible) and 70 ½ (the age where required minimum distributions start), and these distributions are taxed based on your income at the time of withdrawal.

Tax Exempt Investments

While they are few and far between, there are a handful of investment options that can avoid most taxation.

  • 529 College Savings Plans – If you anticipate educational needs for yourself or a family member, 529 savings plans offer an opportunity for investments to grow free of taxes. Though there are restrictions in how the funds can be used, most funds also offer additional state tax incentives on top of tax-free growth.
  • Health Savings Accounts – A kind of account commonly offered by employers, Health Savings Accounts enable you to grow a fund over time that can be spent on medical expenses tax-free. These have been gaining in popularity in recent years, as it not only allows you to reduce your taxable income by whatever amount you contribute but also because you can roll over these funds from year-to-year.
  • Roth IRA – a variant of the Traditional IRA created through new tax laws in 1998. Unlike the 401(k), you contribute to a Roth IRA account using after-tax dollars – i.e., income you have already paid taxes on. Therefore, any earnings you accumulate in this account are tax-exempt upon withdrawal. Starting contributions to a Roth IRA early in your career is also great because if the money has been in the account for five years, you can withdraw the principal at any time – tax-free.

Taxable Accounts

While discussing here a variety of accounts with tax-management benefits, there will be plenty of instances where investments in taxable accounts still provide the best effective return.

These accounts push off different types of income that can be taxed at different levels. There are ordinary tax rates, or the tax bracket you fall into based upon your income level (they include taxation of 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%); and preferential tax rates, or a rate lower than your ordinary rate applied to certain income types (0, 15%, or 20%). The table below outlines how different kinds of income are taxed.

Type of Income versus Taxation Rate

The taxes that are incurred on these types of investments can be managed in some instances through a process called “tax loss harvesting.”  When an investment experiences a loss (a tax loss, but not necessarily an economic loss) and the investor sells the asset, they have realized a capital loss. “Harvesting” these losses mean applying them against short-term and long-term capital gains, which can minimize your overall tax burden. It is important to note, however, that the net amount of capital losses allowed to reduce ordinary income in a year is $3,000, with the remainder getting carried forward to future years. While this is a tool available to potentially reduce your tax burden, it is important to consult your financial advisor to see if this makes sense for your long-term goals.

Taxable Accounts and Tax-Advantaged Accounts*Such as Roth IRAs and tax-deferred accounts including traditional IRAs, 401(k)s, and deferred annuities.

While taxation is only one of many factors in a portfolio, knowing the rules and using them to your advantage can offer benefits for any long-term investment strategy. The best strategies weave many of the principles mentioned here into one harmonious plan, enabling investors to fund various goals while reaping the benefits offered through the tax code. Consider discussing your investment opportunities with a wealth advisor, who can further illuminate the best strategies for your financial goals and life dreams.


Related Resources:

From Bronfman Rothschild: Our Investment Strategy

Market Commentary: 2017 3rd Quarter Review

White Paper: How Do Savvy Investors Plan for Education Expenses?


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Bronfman E.L. Rothschild is a registered investment advisor (dba Bronfman Rothschild). Securities, when offered, are offered through an affiliate, Bronfman E.L. Rothschild Capital, LLC (dba BELR Capital, LLC), member FINRA/SIPC.
This information should not be construed as a recommendation, offer to sell, or solicitation of an offer to buy a particular security or investment strategy. The commentary provided is for informational purposes only and should not be relied upon for accounting, legal, or tax advice. While the information is deemed reliable, Bronfman Rothschild cannot guarantee its accuracy, completeness, or suitability for any purpose, and makes no warranties with regard to the results to be obtained from its use. Past performance does not guarantee future results. © 2017 Bronfman Rothschild.
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