Taxes are a reality you cannot escape, even when it comes to investing. While they may not be top of mind when you are focused on returns, how much you are paying in taxes can be “a significant headwind to long-term returns,” said Fidelity.
By paying attention to how much of your investment income is getting diverted to taxes, you will not only save on that expense — you can also increase your returns. That is because “money that isn’t paid in taxes can stay invested, offering the potential for extra growth and compounding.” Down the road, this can potentially have “a significant impact on the total value of a portfolio,” said Fidelity.
1. Understand when you will pay taxes on investments
The first step in investing tax efficiently is understanding the different types of investment taxes that exist and when you will pay them. “Most investments are taxed in two separate ways. First, on the cash flow generated by the investment, and second, from the sale of the investment itself,” Logan Allec, the CPA and founder of tax relief company Choice Tax Relief, said to Time.
The first refers to tax on dividends and interest that you earn in your portfolio. “Interest and ‘ordinary dividends’ are taxed at your income tax rate (besides income from municipal bonds, which is exempt from federal taxes and might be exempt from state taxes ),” said Ellevest, whereas “‘qualified dividends’ — which have to meet specific IRS criteria — are taxed at the long-term capital gain rate.”
The sale of the asset itself triggers what is known as capital gains tax. Effectively, “the money you make on the sale of any of these items is your capital gain,” and you will owe tax on that gain, said NerdWallet. The rate you’ll pay, however, “depends in part on how long you held the asset before selling.” For assets held for more than a year, you will pay 0%, 15% or 20%, while “capital gains taxes on most assets held for less than a year correspond to ordinary income tax rates.”
2. Invest in tax-efficient assets
As it turns out, “some assets, often those that regularly produce interest, dividends or distributions subject to capital gains taxes, are by nature less tax-efficient than others,” said Fidelity. Examples of these assets include “bonds and bond funds,” “real estate investment trusts (REITs)” and “actively managed stock funds.”
On the other hand, other investments “generate little or not taxable income,” such as “municipal bonds or ETFs,” “passively managed index funds and ETFs” and “tax-efficient active mutual funds,” said Fidelity.
Of course, “a tax-smart portfolio begins with the right asset mix for your time horizon and risk tolerance,” said Fidelity, citing Naveen Malwal, an institutional portfolio manager for Strategic Advisers, LLC — but you can always factor in tax-efficient decisions that align with that larger vision as well.
3. Take advantage of tax-advantaged accounts
On a similar note, it is helpful to invest your money in types of accounts that offer tax advantages, such as retirement 401(k) plans and IRAs. With traditional IRAs and employer-sponsored 401(k) plans, contributions “are made pre-tax, which lowers your taxable income for the year,” said Time. Further, “investments grow tax free and you pay income tax on withdrawals in retirement.”
There is also the option of the Roth IRA or 401(k), which offer a different set of tax benefits. While contributions “are not deductible,” investments “grow tax-free and you won’t pay taxes on distributions in retirement,” said Time.
4. Aim to buy and hold
“An important caveat on the IRS tax laws is that you’re taxed only on realized capital gains, that is, when you sell an investment for cash,” said Bankrate. In other words, “as long as you don’t sell, you won’t be liable for capital gains taxes, which can be substantial.”
Even if you do not want to sit on your investment forever, even just hanging onto it for longer than a year can help. That is because long-term capital gains tax rates “are typically lower than what you’ll pay on short-term capital gains, which are taxable at the ordinary income rate.”