(Today’s guest post comes to you from Fiona Smith, the founder of The Millennial Money Woman. She would like to share the following disclaimer: This article reflects my own views, ideas, and opinions. I am not an investment advisor and I always recommend you communicate with your accountant and financial advisor before investing.)
If you’re looking to build long-term wealth, then a proven strategy is putting your money to work in places like the stock market.
By investing over a long period of time, you can take advantage of what Albert Einstein reportedly once dubbed as the “eighth wonder of the world,” also known as compound interest.
Through the power of compound interest, you can build generational wealth and in many cases, you can earn multiple income streams through either dividends, direct payouts, or other forms of passive income.
While building wealth over time and earning passive income can certainly change your financial trajectory for the better, it’s important to consider some of the potential tax consequences that investing could pose.
One concern that comes to mind is mitigating your overall tax liability from passive income producing investments. If you implement your investment strategies properly, you could create tax efficiencies with income generating investments.
Another concern is maximizing your overall bottom line net return from investments. Not only should you minimize expense ratios, which could eat into your net returns, but you should also take a closer look at minimizing taxes.
Arguably, the most overlooked investing strategy is investing for tax efficiency. Investing efficiently from a tax perspective can truly benefit investors of all levels and ultimately build significant savings over time.
Key Takeaways:
- Invest in a mix of both taxable (non-qualified) and tax-deferred (qualified) investment accounts
- Allocate passive investments in taxable accounts to maximize tax efficiency
- Allocate actively managed investments in tax-deferred accounts
- Implement a tax-loss harvesting strategy to offset your tax liability during periods of market volatility
The 3 Investing Strategies to Boost Your Tax Efficiency
The three investing strategies for tax efficiency that we’ll discuss today include:
- Tax-loss harvesting
- Strategic asset placement
- Leveraging non-actively managed investments
Let’s dive right in.
Strategy #1: Tax-Loss Harvesting
Perhaps the most advantageous investment strategy to boost tax efficiency is tax-loss harvesting.
Tax-loss harvesting is when you strategically sell an investment, especially during times of economic volatility, for a loss. You then use that realized loss to offset a gain generated by other investments in your portfolio. Tax-loss harvesting is technically an active investment management style with the goal of tax neutrality.
If you realize more capital losses than gains, you can deduct your investment losses from your taxable income for up to $3,000 for any given tax year (per 2022 rules). If you maintain capital losses in excess of the $3,000 annual cap, you can elect to carry forward your losses and deduct the losses against your income in future years. (And I’d suggest keeping meticulous records and consulting your tax advisor).
Tax-loss harvesting requires a more intimate knowledge of both your current tax picture and your investment gains or losses.
While no one likes stock market volatility, it’s important to make lemonade out of lemons, and you can have your lemonade with tax-loss harvesting. During short-term market declines, you should act fast by reviewing your current investment positions, cost basis, gains, and losses. Your cost basis (the amount of money you originally invested) ultimately determines how much you either lost or gained in a certain investment.
Tax-loss harvesting may require you to sell out of assets that fulfill your overall investment risk profile in order to capture a gain or a loss. To reconcile your portfolio allocation after the strategic sale of an investment, you should replace the sold investments with similar funds, stocks, ETFs, etc. to preserve the integrity of your portfolio allocation and maintain adequate market exposure.
While you can replace an old investment you sold for tax-loss harvesting purposes with a similar investment, it’s important that you are vigilant of the wash sale rule.
The wash sale rule prevents you from selling a stock or fund to capitalize on its loss and minimize your tax liability and then buy that very same stock or fund (or one that is almost identical) within 30 days.
There is a way to work around the wash sale rule, however: Purchase a stock that is in the same industry, in an effort to preserve your investment allocation. For example, if you sell Verizon to harvest losses and replace Verizon with exposure to AT&T, in most cases, this trade should be acceptable. Of course, you can also repurchase the same stock after initially selling it, but you’ll just have to wait (and most experts recommend waiting for at least 31 days, to be safe).
Tax-loss harvesting applies only to taxable (non-qualified) investment accounts and not qualified (tax-deferred) investment accounts, like IRA’s, 401(k)’s, etc.
If the economy is stable throughout the year, then implement the tax-loss harvesting strategy toward the end of the year. On the other hand, if you are facing turbulent market conditions during the calendar year, then systematically and opportunistically take losses during these periods of volatility.
To make the most out of your tax-loss harvesting strategy, you should speak with both your wealth advisor and your accountant.
Strategy #2: The Asset Placement Strategy
The next time you log into your investment profile, take a look at the tax status of your accounts. In general, most investment accounts fall into 2 categories: qualified and non-qualified.
Common examples of tax deferred investment accounts include your workplace 401(k) or 403(b) plans as well as IRAs. With tax deferred investment plans, you don’t pay taxes on investment gains in the current year, assuming you don’t take withdrawals. Even better, if your contributions are classified as after-tax (or Roth), you may never have to pay taxes on withdrawals and investment gains, assuming you have followed all applicable IRS rules.
Common examples of non-qualified accounts include your everyday joint or individual investment accounts.
Here’s how you can become a more tax-efficient investor:
First, determine the type(s) of accounts you’re invested in (qualified versus non-qualified).
Second, determine the percent of your net worth that is invested in each of the qualified vs. non-qualified accounts. A truly efficient investment strategy would consider strategically allocating your investments in both buckets while making periodic allocation adjustments over time.
If you find that you’re overweight in qualified (tax-deferred) assets, for example, then diversify your investments into non-qualified accounts as well.
Third, determine the investment type (investments generating long-term capital gains vs. short-term capital gains) that is held in each of your accounts.
If you’re not planning to day trade and if you want to invest for the long-term, then a common practice is to hold individual stocks, ETFs, and other assets that can generate long-term capital gains at a lower tax bracket in taxable accounts. Municipal bonds are another good fit for taxable accounts since they are often exempt from federal (and sometimes even state) taxes.
On the other hand, if you own investments that generate ordinary income, you should hold these in qualified accounts. Assets that generate dividends (for example) are better held in tax-deferred accounts because you won’t have to pay taxes in the current year (assuming you make no withdrawals from that account).
If you want to become a more tax-efficient investor, then move tax-inefficient investments into your qualified accounts. Examples of tax-inefficient investments include taxable bonds, alternative investments (such as private real estate investment trusts, cryptocurrency, etc.), and actively managed funds.
Strategy #3: Optimized Placement of Non-Actively Managed Assets
A proven strategy that one of the world’s wealthiest men, Warren Buffett, swears by is passive investing.
Passive investing is when you invest in the market through passively managed investment products like index ETFs or index mutual funds. Conversely, actively managed investments such as hedge funds or other privately traded investment products typically employ investment managers that monitor the market for fluctuations and trade in and out of the market, sometimes even on a daily basis.
Not only is the actively managed investment strategy expensive (most hedge funds, private equity, and other alternative investment products come with high expense ratios), but these actively managed products also tend to be less tax efficient.
For example, managers who buy and sell investment products within a time frame of fewer than 12 months may cause you to incur short-term capital gains. Short-term capital gains, unlike long-term capital gains, are taxed at ordinary income rates, which are generally higher than capital gains rates.
If you held an actively managed investment product in a taxable account, then you’ll likely be slapped with a higher tax bill for the current year than if that same actively managed investment was held in a tax-deferred account.
Another item to consider when it comes to actively managed versus passively managed investments is the rate of success. In other words, it is very difficult if not impossible to accurately and, more importantly, consistently predict how the stock market will perform over time.
In fact, one of the most controversial quotes about succeeding in the stock market was brought forth by Burton Malkiel, the author of “A Random Walk Down Wall Street,” who coined the phrase, “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.”
And while this quote certainly remains contentious, there is some truth to the statement. In fact, in early 1999, a chimpanzee randomly aimed and shot 10 darts at a dartboard filled with 133 internet-based businesses. After just 6 trading days, one of the chimpanzee’s choices had increased by 95% in value. Not only did the chimpanzee select a profitable stock in the short term, but its randomly chosen portfolio of 10 stocks also managed to outperform more than 6,000 money managers specialized in technology by the end of 1999. The chimpanzee’s portfolio grew by about 213%.
Of course, this event also occurred during the dotcom bubble, which certainly contributed to the chimpanzee’s portfolio profits. Nevertheless, a point still stands: You don’t always need to actively monitor the stock market and make daily trades to succeed.
So while it might be easier to outperform the stock market in the short term through active management, if you look at the long term perspective, passively managed funds typically outperform actively traded funds.
Passively managed funds are generally index funds that track a particular index, such as the S&P 500 or the Russell 3000. Passive fund managers don’t aim to outperform the market, they just want to perform in line with their chosen index. With minimal trading costs and lower expense ratios, passive investments are great candidates for your taxable accounts.
Closing Thoughts
While it is always important to save and invest consistently for the long term, it’s also important to consider the potential tax implications resulting from your investments.
First, determine whether your accounts are pre-tax or after-tax investment accounts.
Second, determine the percent of your net worth that each of your accounts hold. If you are overweight in qualified (tax-deferred) assets, then make sure to diversify your investments into non-qualified accounts as well.
Third, determine whether the investment types held in each account are actively or passively managed. If they are actively managed and tax-inefficient, then move these investments to tax-deferred accounts. If they are passively managed, then move these investments to taxable accounts.
And finally, remember to collaborate with your accountant and wealth advisor to better determine how to take tax opportunistic losses through tax-loss harvesting, to offset your income and other capital gains.
Fiona Smith is the founder of The Millennial Money Woman. She holds her Master of Science Degree in Personal Financial Planning and has co-founded a local non-profit community teaching financial literacy.
Hi Fiona great article. I’m not sure though you should always diversify into nonqualified accounts if you only have money in qualified accounts. If you are in your peak earning years at higher tax bracket and then will be in lower tax brackets in retirement, really should keep all your money in tax deferred, correct? Even if you’re a super saver and will be at higher tax brackets in retirement I would say might have to look into a plan of Roth conversions until RMD age. Then after that I would consider what you’re saying diversifying in a taxable account.