A solid, evidence-based investment strategy is one of the best ways to put the odds of long-term investment success on your side. But how can you improve those odds even further? One important way is through tax-efficient investing. By making investment decisions with taxes in mind, you can improve your after-tax results—which matter far more to your goals than headline returns alone.
One helpful way to think about tax-efficient investing is as a layered strategy: starting with essential practices and building toward more customized and advanced techniques. Let’s explore.
Foundational: Essential Practices for Every Investor
Use Broadly Diversified, Low Turnover Funds: The foundation of tax-efficient investing begins with minimizing unnecessary trading. High-turnover, actively managed funds often trigger capital gains through frequent buying and selling. In contrast, broadly diversified, low-turnover funds—such as many index mutual funds and exchange-traded funds (ETFs)—not only align with an evidence-based investment philosophy focused on long-term discipline and broad market exposure, but they also tend to create less taxable activity. In fact, many ETFs avoid distributing capital gains altogether, making them especially tax-efficient.
Match Investments to Your Tax Bracket: Different types of investors are drawn to different types of investments based on how they’re taxed. This idea is known as the tax clientele effect. Simply put, people tend to favor investments that make the most sense for their specific tax situation. Tax-aware investing builds on this by tailoring investment choices to match your tax bracket, income sources, and the types of accounts you use—with the aim of reducing your overall tax burden. For example, investors in higher tax brackets often benefit from municipal bonds, which typically pay interest that’s exempt from federal—and sometimes state—income taxes. For those facing a high marginal tax rate, these bonds can be more attractive than comparable taxable bonds.
Strategic: Tailoring Tax Efficiency to Your Goals
Shift Taxable Income Across Time Using Qualified Accounts: One of the most effective tools in tax-efficient investing is the ability to shift taxable income across time using qualified accounts—retirement accounts that receive special tax treatment under IRS rules. These include traditional IRAs, Roth IRAs, and employer-sponsored plans like 401(k)s. The idea is to take advantage of differences in your tax rate at various points in life. For example, contributing to a traditional IRA or 401(k) during high-income years allows you to defer taxes when your rate is higher, with the goal of withdrawing the funds in retirement when you're likely in a lower bracket. On the flip side, contributing to a Roth IRA when your current tax rate is low lets you pay taxes upfront and enjoy tax-free withdrawals later—potentially on a much larger balance. This timing-based strategy, known as intertemporal tax arbitrage, can be especially valuable for younger professionals, early retirees, or anyone with variable income. It requires careful planning to align your contributions with your expected future tax landscape, but done well, it can significantly improve after-tax outcomes over the long term.
Put the Right Investments in the Right Accounts: Some investments are inherently more tax-efficient than others. Interest-generating assets—such as bonds and bond funds—typically produce ordinary income that is taxed annually. For certain investors, particularly those in high-tax states, this income can face combined federal and state tax rates nearing 50%. Because of this, tax-inefficient assets, like bonds, are generally better held in tax-deferred accounts, such as IRAs or low-cost variable annuities, where the income isn't taxed until withdrawal. On the other hand, investments with long-term growth potential and low turnover—like broad index equity funds—are well-suited for taxable accounts, where favorable capital gains treatment can apply. With this in mind, investors can implement a strategy known as asset location. By coordinating a unified investment approach across different types of accounts, they can deliberately place asset classes in the most tax-efficient locations—boosting after-tax returns without altering the portfolio’s overall risk profile.
Turn Losses into Opportunities: Markets move in cycles, and not every investment produces a gain. Tax-loss harvesting involves selling investments that are down to realize a loss, which can offset other capital gains or up to $3,000 of ordinary income annually. Reinvesting proceeds in a similar—but not identical—investment maintains your portfolio exposure while adhering to wash-sale rules. Over time, this practice can help improve tax efficiency without compromising your investment strategy.
Advanced: Tax Optimization for Maximum Impact
SMAs for Direct Indexing and Tax Harvesting: For investors managing larger portfolios, Separately Managed Accounts (SMAs) offer an added layer of tax efficiency. By holding individual securities instead of pooled funds, SMAs enable customized tax-loss harvesting at the stock level. Even in a rising market, some positions may still show losses—providing opportunities to realize those losses while the broader portfolio continues to grow. This more advanced technique is particularly useful for high-income investors or those coordinating their investment strategy with broader financial and tax planning, such as managing low-cost basis stock sales or preparing for major taxable events like the sale of a business or home.
Charitable Giving: Maximize Impact, Minimize Taxes: Charitable strategies can also play a powerful role in tax-efficient investing. Donating long-term appreciated assets—such as stocks with low-cost basis—allows you to avoid capital gains tax while still receiving a full charitable deduction for the fair market value. For those with larger charitable goals or fluctuating income, Donor-Advised Funds (DAFs) provide flexibility. You can make a large, tax-deductible donation in a high-income year, then distribute those funds to charities over time, aligning your charitable goals with your broader financial strategy.
Final Thoughts
Tax-efficient investing is not a one-size-fits-all approach—it evolves with your financial situation, goals, and the tax landscape. Whether you're laying the groundwork by building an investment portfolio with broadly diversified, low-turnover funds or fine-tuning by incorporating SMAs, Donor Advised Funds, and asset location principles, these layers of tax efficiency can work together to support long-term success.
As always, these strategies should align with your comprehensive financial and tax plan. A coordinated effort between your advisor and tax professional helps to ensure that you're making decisions with a full understanding of your entire financial situation - including where you live, which can significantly affect the outcomes of tax strategies due to variations in state and local taxation.
This article is for informational purposes only and does not constitute personalized tax advice. Every taxpayer’s situation is unique, and you should consult a qualified tax professional before making any financial decisions.
