A comprehensive investment strategy can help you address multiple concerns – managing your wealth, saving for retirement, educating your children, creating a legacy and so on. But underlying many of these concerns is the issue of taxes. What steps can you take to become a more tax-efficient investor?
Here are a few suggestions:
Maximize your 401(k)
Unlike a Roth IRA, your 401(k) has no income "phase-out" limits, so you can typically contribute either the lesser of your income or the contribution limit, which, in 2023, is $22,500, or $30,000 if you’re 50 or older. Your pre-tax contributions will reduce your taxable income and your earnings will grow tax deferred. However, your employer may also offer a Roth option for your 401(k), in which your earnings could grow tax-free, generally as long as you’ve had your account at least five years and you’re older than 59½. In the long run, you might be better off choosing the traditional, tax-deferred 401(k) if you think you’ll be in a lower tax bracket during retirement – and since you’re a high earner, this may well be the case. In making this type of decision, you’ll benefit from consulting your tax advisor.
Consider a Roth conversion
As mentioned above, a Roth IRA has income limits, and you may well be exceeding them – but that doesn’t necessarily mean you can never take advantage of this investment vehicle, which, like a Roth 401(k), generally provides tax-free withdrawals as long as you meet the age and length of ownership requirements. You could convert some or all of the money in your traditional IRA into a Roth IRA, though the amount converted will be subject to tax at ordinary income rates. Or you may be able to create a "backdoor" Roth IRA by opening a traditional IRA, making contributions to it and eventually moving those funds to a Roth IRA. Any gains you received in your traditional IRA before the conversion may be subject to tax, so you’d need to have the money available in a liquid account.
Think about an annuity
With a high income, you may be in a position to "max out" on your 401(k) and your IRA. When you do, you might want to consider investing in a fixed annuity. Your earnings will accumulate tax deferred and generally won’t be treated as taxable income until you start taking payments. And you may be able to structure an annuity to provide you with an income stream you can’t outlive.
Buy and hold
One of the best, and easiest, tax-efficient techniques you can employ is simply to avoid excessive trading of your investments. By following a "buy and hold" strategy, you should only have to pay the long-term capital gains tax rate – which is likely to be either 15% or 20% in your case – on the investment's appreciation when you sell individual stocks you’ve held for over a year.
Seek tax-efficient mutual funds
You don’t have to buy and sell a lot of mutual funds to generate taxable gains, because the fund managers themselves can make trades often, and these trades can produce capital gains, whose tax liability will generally be passed on to you. Also, some mutual funds pay out a lot of taxable dividends. So, a fund that does relatively little trading or pays fewer dividends could be considered tax-efficient, as could index funds and exchange-traded funds (ETFs), which have little or no turnover. Keep in mind, though, that taxes should just be one component of your decision to invest in certain funds – you also need to evaluate other key factors, such as whether the fund can help you make progress toward your goals.
Look at municipal bonds
The interest from municipal bonds is generally exempt from federal income tax, and often from state and local income taxes, too. However, the income from some municipal bonds may be subject to the alternative minimum tax. Generally speaking, the higher your tax bracket, the more you may benefit from municipal bonds as opposed to taxable corporate bonds.
To learn more about these and other tax-efficient investing ideas, contact an Edward Jones financial advisor. You may also want to consult with your tax advisor on the tax consequences of specific investments. Becoming a “tax-smart” investor may help you get more mileage from your portfolio, which may pay off for you – now and during retirement.
Senior Strategist, Retirement
Senior Strategist, Retirement
Katherine Tierney is a Senior Retirement Strategist on the Client Needs Research team at Edward Jones. The Client Needs Research team develops and communicates advice and guidance for client needs, including retirement, education, preparing for the unexpected and leaving a legacy. Katherine has more than 15 years of financial services and retirement experience. She is a contributor to Edward Jones Perspectives and has been quoted in various publications.
Edward Jones, its employees and financial advisors cannot provide tax or legal advice. You should consult your attorney or qualified tax advisor regarding your situation. This content should not be depended upon for other than broadly informational purposes. Specific questions should be referred to a qualified tax professional.