How to Be a Tax-Efficient Investor

First, the good news: That extra dollar or $1,000 or $10,000 that you scraped out of your paychecks and invested has actually earned you some money. Now the bad news: Uncle Sam is waiting at your door with his hand out because the Internal Revenue Service wants its share of that money. 

You have several options to minimize the blow. The IRS has historically given a nod of approval and a helping hand to savings and investment vehicles that the government deems to be in the best interests of the individual taxpayer and society in general. These include saving for retirement and investing in a home. But, of course, the IRS applies numerous rules to each tax provision.

KEY TAKEAWAYS

• Being strategic about your investments regarding their tax consequences can help ensure that your savings goals aren't negatively impacted by your tax bill.
• It's important to look at what your money is invested in, such as stocks, real estate, bonds, mutual funds, and savings accounts, and make sure you understand what the tax implications are for each.
• Holding stocks for more than a year before you sell them can lower the amount of capital gains taxes you'll have to pay on the profits you realize from any sale.
• One advantage of having a 401(k) is that you generally don't have to pay income tax on your contributions in the year in which you make them.
• Don't forget that you may be able to offset your capital gains with capital losses, a procedure known as tax loss harvesting.

The Importance of Tax-Efficient Investing

Investing makes no sense if you have to turn the rewards over to the government. Not only do you lose some of the money, but you also lose its potential for growth if it had remained invested. This growth potential directly impacts whatever you were saving for in the first place, such as a comfortable financial cushion in retirement. For this reason, you want to be strategic about your investments when it comes to their tax consequences.

Types of Investment Taxes and How to Minimize Them

Tax efficiency depends a great deal on how and where you invest your money. Here’s a look at various types of investments and their different tax rates, provisions, and rules.

Capital Gains Taxes

A capital gain is the difference between the amount of money you've invested and the amount you receive for the asset at the time you dispose of it. Let’s say that you invested $10,000 in an asset and then sold it for $15,000. You would have a capital gain of $5,000 that’s subject to its own tax rate—one that’s typically lower than the rate at which your regular income is taxed.  

If you sold the asset instead for $5,000, you would have a capital loss of $5,000, but you can use this to your advantage because many losses are tax deductible, although losses resulting from selling personal property, such as your car, are not. (See more on this in the section, “Another Consideration for Tax-Efficient Investing.”) You’re taxed on your net capital gain—the amount that is added into your assessable income—for the year, from which you can subtract any capital loss.

When it comes to capital gains tax, your period of ownership is pivotal. If you hold the asset for one year or less, you’re taxed at the short-term capital gains rate, which is the same as the rate applied to your ordinary income. For a higher earner it can be as much as 37%. But if you own the asset for a year plus one day or longer, the rate drops to a long-term capital gains tax rate of 0%, 15%, or 20%. Long-term capital gains tax rates break down according to income, with the following figures applying to the 2023 tax year.

The 0% long-term capital gains tax rate applies to taxable annual incomes of:

• $44,625 or less (single filers)
• $89,250 or less (married filing jointly)   
• $59,750 or less (head of household) 

The 15% long-term capital gains tax rate applies to taxable incomes of: 

• $44,626 to $492,300 (single filers)
• $89,251 to $553,850 (married filing jointly)
• $59,751 to $523,050 (head of household)

Long-term capital gains are taxed at 20% if your income exceeds the applicable 15% threshold, but that’s still significantly less than the 37% rate that would apply to your ordinary income and short-term capital gains. And some gains are tagged with a 28% rate, including those resulting from the sale of collectibles (think artwork here).

Net Investment Income Tax

The net investment income tax applies to your overall investment income above certain income thresholds that also depend on your tax filing status. Investment income derives from dividends, interest, royalties, some annuities, and some real estate as well as mutual funds, stocks, and bonds. These earnings come with a 3.8% tax rate that’s applied to your net investment income or the amount of your modified adjusted gross income over certain thresholds, whichever is less. 

The 2023 tax year income thresholds are: 

• $200,000 (single or head of household)
• $250,000 (married filing jointly)
• $125,000 (married filing separately)

Other Taxes on Interest

Assuming that you dodge the net investment income tax, interest income is taxed as regular income according to the tax brackets for your filing status. It’s taxable in the year it’s paid to you whether you receive a check in the mail or it’s deposited to an interest-earning account into which you’ve placed your money. 

Taxable interest can be derived from a wide swath of investment options, including mutual funds in some cases, money market accounts, savings accounts, certificates of deposit, bonds, and treasury bills and notes.

401(k) Investment Taxes

A 401(k) plan is a savings vehicle that allows you to save for retirement with a few tax perks along the way. It’s generally set up through your employer and your employer will usually make contributions on your behalf as well. You can contribute a percentage of your paycheck to your 401(k) account and you don’t have to pay income tax on that money in the year you make the contribution. You’ll pay tax on it eventually at the time you withdraw the money, presumably in retirement, but many taxpayers find themselves in a lower tax bracket in their retirement years.

Let’s say that you contribute $3,000 to your 401(k) in a year when your taxable income subjects you to a tax rate of 32%. That $3,000 is subtracted from your taxable income. It remains in your 401(k) plan and grows nicely for a decade or two or three. You withdraw the money in retirement when you’re earning less so you fall into a 22% tax bracket in that year. You’ve saved 10% in taxes on that money.  

But income limits apply to 401(k) contributions as well. You can’t can’t contribute on compensation that exceeds $330,000 in tax year 2023. Any income you earn over this amount cannot be included as a contribution percentage of your pay.

You’ll pay a 10% penalty if you withdraw money from your 401(k) early, before retirement, before a minimum mandated age of 59½.

Mutual Funds Taxes

A mutual fund is a regulated investment company. It takes investors’ money into a pool that’s contributed by other investors and is then invested and managed by the fund. You own shares of the fund, but the fund itself owns the investments. It makes money when you make money and when you sell your shares at a gain.

You don’t personally have a lot of control over taxation of this income. It’s a long-term capital gain to you if the fund held the asset in question for more than a year. Otherwise, it’s a short-term capital gain, and taxed as taxed as ordinary income, which is your personal income tax rate.

You don’t get to dictate how long you want the asset held. You (and the IRS) will receive a Form 1099-DIV from the fund telling you how long your investment was held and how your gain has been classified.

Mutual funds are required to pass their gains on to their investors annually so you’ll owe tax regardless of whether you personally sold any of your shares back to the fund or to another investor.

The good news here is that you can have a long-term capital gain at the kinder rate even if you bought into the fund yesterday and you personally owned your shares for only one day. The calendar countdown begins with the date when the fund bought into the asset.

Home Sale Taxes

The Internal Revenue Code really supports homeownership. Investing in the roof over your head and then selling it comes with a nice tax advantage, subject to some rules. 

The IRS offers the Section 121 exclusion, which shields up to $250,000 in profit from capital gains tax if you’re single, or $500,000 if you’re married and file a joint tax return. You might purchase your home for $300,000 then sell it for a sweet $500,000 years later. That’s a $200,000 gain that you can pocket tax-free because it’s less than the filing status thresholds.  

Of course, this is federal tax law so rules apply. You must have owned the home and lived in it, using it as your main, primary residence, for at least two of the five years preceding the date of sale. 

The ownership period and the residency period don’t have to coincide, however. You can live there for two years then move out and rent it to a tenant for another two years and that’s fine. But here’s the catch: Both periods must occur within five years. Again, timing is everything.

Where to Place Investments

The calendar is clearly your friend when it comes to tax-efficient investing and should be considered along with potential rates of return and other factors. But some of those other factors can make you look pretty tax-savvy as well. 

The Internal Revenue Code provides a few goodies to reward you for investing your money in such a way as to promote the greater good. It’s much less likely that an individual will have need of government financial assistance in their later years if they have healthy retirement savings. 

The IRS therefore offers encouragement in the form of the Saver’s Credit, more professionally known as the Retirement Savings Contributions Credit, introduced in 2002.

You can claim this tax credit for investing money in a retirement account, such as a traditional or Roth IRA or a 401(k). The amount of the credit ranges from $1,000 to $4,000 depending on your filing status and income.

And here’s another bit of good news: It’s a tax credit, not a tax deduction. This means that the credit amount comes directly off what you owe the IRS when you complete your tax return rather than off your income—what’s known as dollar-for-dollar savings.

You might also consider investing your money in such a way as to earn nontaxable income. You have a few choices here:

• Insurance dividends that are left on deposit with the U.S. Department of Veterans Affairs
• Bonds that are issued by a state, the District of Columbia, or a U.S. territory and are used to finance government operations
• Series EE and Series I savings bonds you ultimately use to pay for qualified higher education expenses, which are subject to some rules

Your money can grow tax-free in any of these vehicles.

Another Consideration

Don’t forget tax-loss harvesting, the process of offsetting capital gains with capital losses referred to earlier… and yes, losses are almost inevitable eventually.

It works like this. You’re sitting on an underperforming investment that you wish you had never touched. So you decide you’re done with it and you sell it, taking the loss. You can then subtract that loss from your taxable capital gains, paying taxes on less.

But there’s a catch here, too. You can’t take the money from the sale and reinvest those dollars into the same type of investment that you sold. It must be a different type of investment or security.

What Does "Tax-Efficient Investment" Mean?

A tax-efficient investment is one that minimizes your tax burden and maximizes your bottom line. Investment accounts are either taxable or tax-advantaged. An example of a taxable account is a brokerage account, where the taxes you pay depend on how long you hold an asset before you sell it. An example of a tax-advantaged account is a traditional IRA, which can provide an immediate tax break. Both types of accounts can be tax efficient investments.

What Is the Most Tax-Efficient Way to Invest?

There are numerous way to invest tax efficiently. Retirement accounts may allow for tax-free contributions or tax-free withdrawals in retirement. Stocks have significant potential for growth and any income you derive from them is usually taxed at a lower capital gains tax rate instead of your personal income tax rate. And municipal bonds can be especially tax efficient—their interest income isn't taxable at the federal level and may be tax-exempt at the state and local level as well. It's wise to have a strategy that combines different types of tax-efficient accounts.

What Can I Invest in to Reduce My Taxable Income?

One way to reduce your taxable income is to invest in an employer-sponsored retirement account such as a 401(k). In 2023 you can contribute $22,500—or $30,000 with a catch-up contribution of $7,500 if you are 50 or older. In 2024, the contribution limit increases to $23,000, but the catch-up contribution remains the same. Since contributions are made with pre-tax dollars, they can lower you taxable income for the year in which you make them, potentially lowering your tax bill.

The Bottom Line

Savvy investors have numerous options to dodge the tax bullet. The one that suits you best can depend on your overall income, your tax-filing status, and your goals for the money you've earned. What do you want to do with it? How long are you willing to wait to sell for a profit? Also, the value of consulting with a tax professional can't be overlooked so you're sure you get your plan just right.

Overall, investment taxes are very specific to each investor and their strategy. Make sure you have a full understanding of your financial situation and ensure the professionals you work with are informed and can truly help minimize your tax liabilities.