7 Ways to Invest More Tax Efficiently

Like a layer cake, tax efficient strategies can be stacked

A layer cake representing layers of tax efficiency.
••• Steve Buchanan/Getty Images

I think of tax efficient investing like a seven layer cake. The more layers you add, the more you can increase your after-tax retirement cash flow that will be available to you. Starting from the simplest to most complex, below are seven ways to change the way you invest in order to lower your taxes.

1. Own Tax-Efficient Funds in Non-Retirement Accounts

 “Some investors are surprised to find that they have to pay taxes on capital gain and dividend distributions from their mutual funds and ETFs, even if they didn’t sell their funds during the year. In fact, over the past 10 years, the average annual tax cost for a mutual fund was 1.3%.1.”

1. Source: Morningstar as of 3/31/14. “Tax Cost” is a Morningstar measure of the impact of taxes on capital gains and income distributions on performance. Averages are calculated using the oldest share class of all actively managed open-end mutual funds available in the U.S. (excluding municipal bond and money market funds) with 10-year track records as of 3/31/14.

Some mutual funds have a high turnover which results in short-term capital gains distributions each year. Such distributions are taxed at a higher tax rate than long-term capital gain or qualified dividends. By choosing index funds or tax-managed funds in non-retirement accounts you can lower your tax bill.

2. Use a Process Called Asset Location

You can locate your investment holdings across taxable vs. tax-deferred accounts in a way designed to reduce the amount of taxable portfolio income you have each year. Here is a generic set of asset location rules to consider:

  • Place investments that have the potential for the highest returns inside your Roth account. This would be holding such as small cap and emerging markets.
  • Hold investments that generate long-term gains and qualified dividends in non-retirement accounts. This would be things like an S&P index fund or dividend paying stocks.
  • Hold fixed income and high turnover investments in traditional tax-deferred accounts. This would be things like commodity funds, real estate funds, actively managed funds), and bond funds.
  • Higher tax bracket households should consider using municipal bonds for fixed income held in non-retirement accounts.

3. Harvest gains and losses based on your tax situation

If your tax bracket is low (15% or lower) you may fall into the zero percent capital gains tax bracket – meaning you will pay not tax on realized capital gains. You can use a tax projection to see what years this may occur an intentionally realize gains in years where they will not be taxed.

Higher income folks should realize any available capital losses every year when that loss can be used against ordinary income. You can also harvest losses to offset other capital gains that you may have.

4. Fund retirement accounts based on your tax bracket

Tax-free growth is hard to find and both Health Savings Accounts and Roth accounts offer the ability to grow funds tax-free, so in general, I think everyone who is eligible to do so should fund these types of accounts. It also makes sense to fund company accounts in an amount sufficient to get the full match. A company match provides an instant return on investment.

Once those items are in place, your tax bracket now and in the future determines what you should fund next. Below are a general set of funding guidelines:

  • Fund Roths when your current marginal tax bracket is the same or lower than your expected marginal rate in retirement.
  • Fund deductible accounts when your current marginal rate is higher than your expected marginal rate in retirement.
  • Fully fund all types of accounts to get maximum creditor protection. In some states, for high income/high-risk professions, this may include funding annuities and cash value life insurance.

5. Withdraw tax efficiently in retirement

Social Security is a tax-preferred source of income. At most 85% of Social Security retirement benefits will be subject to income taxation. This increases the potential benefit of delaying the start date of your Social Security so you get more lifetime income that is tax-preferred.

In some circumstances, most often occurring for those without much pension income and with moderate IRA account balances, using IRA withdrawals early in retirement while delaying Social Security can be quite beneficial and improve your outcome when compared to other withdrawal strategies.

6. Plan based on a general set of assumptions

Many people make assumptions about their tax bracket now and what they think it will look like in retirement. Most financial planners also use generic assumptions. This is better than doing no planning at all, but I think a customized set of assumptions is always better than using a generic rule of thumb. The best planning comes from running a personal long-term tax projection and from getting advice based on your personal situation.

This article is full of generic rules – don’t blindly apply them. I don’t know your personal situation and you may have circumstances that mean some of the guidelines suggested in this article would not be appropriate for you. No book, article or online advice forum can surpass the value that a personalized analysis done by a qualified financial planner or tax advisor can offer.

7. Plan based on a personal tax projection

Amazingly enough, many who thought their tax rate would be lower in retirement find out that isn’t true. This happens most frequently to those who faithfully contributed to tax-deferred retirement plans and end up with a lot of money in IRAs and 401(k)s.

A long-term tax projection would have illustrated their future tax path and helped them make earlier decisions that could have improved their balance between pre-tax and after-tax savings. For most, you don’t want to reach retirement with all your assets in tax-deferred retirement plans. This will mean every dollar you need to withdraw will be taxed, so you may have to withdraw $1.40 or more for every dollar you need to spend. Those who have the greatest amount of financial stability in retirement usually have a balance of savings across various account types.