No one enjoys handing money over to the IRS, but everyone is responsible for paying taxes. Taking advantage of tax-efficient investing options can help you reap the benefits of certain tax breaks, especially if you fall into a higher tax bracket.
What is the most tax-efficient way to invest money?
The most tax-efficient way to invest money depends on your personal financial situation but generally includes using tax-advantaged accounts to house investments that may generate a lot of taxable income or taxable gains, and using non-tax-advantaged accounts to house investments that don’t generate much taxable income or taxable gains.
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Tax-advantaged accounts such as 401(k)s, IRAs, 529s, health savings accounts and irrevocable trusts can be a better place to house investments that may generate a lot of taxable income or taxable gains.
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Taxable brokerage accounts may be a better place to put less actively traded or more tax-efficient investments.
Here’s how to use these accounts and investments to minimize your tax bill.
🤓Nerdy Tip
A tax-advantaged account is an account that receives special tax benefits such as tax deductions for contributing to the account, deferral of the capital gains tax or income tax generated by investments in the account, or even tax-free withdrawals. By eliminating or deferring taxes on investments that are inside tax-deferred accounts, the account owner can keep more of their money and build wealth faster.
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Contributions are tax-deductible.
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Earnings are tax-deferred, which means you will be responsible for paying income taxes on distributions in the future.
Health savings accounts (HSAs)
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Contributions are tax-deductible.
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The money in the account grows tax-deferred.
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Withdrawals are tax-free when used for qualified medical expenses.
Types of tax-efficient securities
Some investments are more tax-efficient than others, regardless of what type of account they’re in.
Mutual funds vs. index funds and exchange-traded funds
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Actively managed mutual funds can generate taxable capital gains that pass through to the investor. (Some actively managed mutual funds are managed to reduce investors’ tax liabilities, but the added tax benefits often come with higher fees.)
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Passively managed mutual funds, such as index funds, often mimic an underlying benchmark index and are generally more tax-efficient than active mutual funds. This is because index funds usually buy and hold their positions and thus generate fewer taxable capital gains.
Proceeds from life insurance, both permanent and term, are usually tax-free. Permanent life insurance policies accumulate cash value while deferring taxes, and policyholders can borrow up to the cost basis, or the sum of the premiums paid in, of their life insurance policy without being subject to tax.
Other tax-efficient investing strategies
Beyond asset location and investment selection, you can use other strategies in an effort to pare back your tax burden.
Managing long-term and short-term capital gains
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Short-term capital gains tax rates generally apply when selling an investment held for one year or less. The rates are the same as the ordinary income tax rates and range as high as 37%.
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Long-term capital gains tax rates generally apply to investments held longer than a year. The rates are 0%, 15% or 20%, depending on your filing status and income level. If you can wait to get past that one-year mark before selling investments with capital gains, you’ll likely pay a lower tax rate.
🤓Nerdy Tip
As mutual fund managers trade, trim and add to various positions, the fund can generate capital gains and income distributions. Sometimes the fund will have enough losses to offset the gains, but any outstanding gains must be distributed to and are taxable for shareholders. Mutual fund companies publish estimates of capital gain distributions toward the end of the year. If these capital gains distributions are significant, you can consider selling your shares of that fund and buying another mutual fund or ETF before the distribution hits.
