Keep more for yourself
As an investor, you have two sides: the tax-advantaged side and the currently taxable side.
While it is always wise to think of your portfolio as one entity, it can be helpful to think of you yourself as two kinds of investors. On the one hand, you’re probably planning for your future by contributing to a government sanctioned tax-advantaged retirement plan such as a 401(k) or a traditional or Roth IRA.
In addition, you may be investing in a brokerage account, where the money is currently taxable. This is where you can put money beyond what you can contribute to your retirement accounts or the money that you have earmarked for shorter-term goals.
Take full advantage of tax-advantaged accounts
Tax-advantaged accounts such as 401(k)s and IRAs are an investor’s best friend. This is because of two things:
First, the earning in these accounts grow tax-free (although they may be subject to tax when withdrawn). The entire amount you invest in these accounts compounds free of taxation—potentially for decades. The chunk of money that would otherwise go to the government is instead working for you, and compounding. Over time, this makes a huge difference.
Second, depending on the plan and on your circumstances, you may be able to deduct your contribution from your taxable income, leaving you that much more money to invest. Withdrawals from Roth IRAs are not taxed at all because they are funded with after-tax dollars.
Choosing the best investments for your accounts
Where you hold different types of investments—in a taxable or tax-advantaged account—can have a big impact on your taxes.
Some investments—such as equity index mutual funds, stocks held over one year and municipal bonds—are by their very nature tax-efficient. It makes sense to keep these in your taxable accounts when you have a choice.
Other less tax-efficient investments—such as individual stocks that you buy and sell more frequently, actively managed mutual funds and taxable bonds—could be good choices for your retirement accounts.
You can use this chart to help you decide what type of account is best from a tax perspective:
|Tax-Smart Ways to Invest|
|In taxable brokerage accounts ...||In tax-deferred accounts ...|
|Individual stocks you plan to hold more than one year||Individual stocks you plan to hold one year or less|
|Tax-managed stock funds, index funds, low-turnover stock funds||Actively managed funds that generate significant short-term capital gains|
|Stock or mutual funds with qualified dividends that are subject to lower tax rates||Taxable bond funds, zero-coupon bonds, inflation-protecting bonds or high-yield bond funds|
|Municipal bonds, I Bonds (savings bonds)||Real Estate Investment Trusts (REITs)|
Understanding how capital gains are taxed
A capital gain is the profit you receive when you sell an investment for more than you paid. You have to pay tax on this gain. There are two types of capital gains taxes:
- Long-term capital gains tax—Gains on stocks, bonds and mutual funds held over one year are currently taxed at a maximum federal long-term capital gains rate of 15 percent.
- Short-term capital gains tax—If you hold investments for one year or less, they are subject to ordinary federal income tax, which ranges up to 35 percent.