Taxes should not be the primary driver of investment strategies, but they should certainly be taken into account. Investment strategies that manage, defer, or reduce federal income tax may often prove attractive.
By reducing taxes, it’s possible to retain more money for investment purposes–and take advantage of compounding growth potential. There are multiple strategies for tax-efficient investing such as using tax-advantaged accounts or choosing investments with reduced tax liabilities.
1. Tax-loss harvesting
Taxes can be an investment performance drain, but you can offset their impact with smart strategies. Tax-loss harvesting is one such tactic; this involves selling losing investments to offset gains that would otherwise incur tax liability and lower cost basis, ultimately increasing after-tax returns over time.
Tax loss harvesting should be executed as part of a thoughtful investment strategy and account structure, taking note of the 30-day wash sale rule which can disallow losses if an identical investment is purchased within 30 days after you sell losses harvested through tax loss harvesting. While immediate tax savings are significant, long-term capital is freed up that could be better invested elsewhere – be sure to discuss your plan with a financial advisor so they ensure it aligns with your overall objectives!
2. Tax-efficient investment vehicles
Taxes should never be the primary focus of investment decisions, but they’re an important consideration. There are ways to minimize taxes with tax-advantaged accounts and investments designed specifically to minimize them.
Vehicle structure and strategy should also be considered when selecting investment vehicles. Active equity open-end funds (OEFs) often trade frequently to achieve outperformance, leading to capital gains distributions which may incur taxes. By comparison, index exchange-traded funds (ETFs) tend to trade less frequently and thus tend to be more tax efficient; similarly tax-managed separately managed accounts (SMAs) aim to maximize after-tax returns by harvesting unrealized capital losses to counterbalance any gains taxed against them year round.
Specific investments may provide tax-efficient features. For instance, interest income from municipal bonds tends to be taxed at a lower rate than ordinary income and may even be exempt at the state and local levels. Your Edward Jones financial advisor can assist in identifying ways of minimizing taxes while meeting diversification, liquidity and investment goals at once.
3. Tax-advantaged accounts
Your account of choice and investment selections can have a dramatic effect on your tax liability. Investments with substantial capital gains tend to work best with tax-deferred accounts like an IRA or 401(k), while others might work better in taxable brokerage accounts.
Tax treatment of investments depends on their type and length of holding period. Therefore, asset location strategies that take advantage of tax loss harvesting or store investments with different tax properties in accounts that best suit them can help minimize your tax bill.
Taxes should never dictate your investment decisions; however, factoring them in can increase returns by minimizing what you owe. A comprehensive investment strategy must take into account goals, finances, timeline, risk tolerance and taxes when creating an overall strategy – otherwise they could stymie growth of investments and undermine long-term goals.
4. Tax-exempt bonds
Investors typically devote considerable effort and time researching investments with attractive return prospects, yet often fail to account for tax considerations when creating an overall investing strategy. Making tax efficiency part of that plan may help lower after-tax returns and maximize after-tax returns.
Some investment vehicles, like index funds and ETFs, are designed to minimize taxable distributions – helping you lower capital gains taxes.
Real estate investments often provide advantageous capital gains tax treatment, while municipal bond interest may be tax-exempt. Furthermore, investment income from real estate can often be deferred and may qualify for favorable alternative minimum tax treatments.
Consideration of the tax impact of investing decisions is of critical importance regardless of whether your account is tax-advantaged or taxable. A Morgan Stanley Financial Advisor can work with you to assess how they could impact your taxes before exploring possible changes that could help achieve your goals more quickly.
