Tax-efficient investing for high-income earners

Every dollar saved in taxes is one more you can spend, save, give or leave as a legacy. Where you save, what investments you own and when you trade can impact your taxable income and after-tax investment returns. Here are three tax-smart strategies to consider for potentially reducing taxes now or in the future.

1. Save in tax-advantaged accounts.

Tax-advantaged accounts, like a 401(k) or IRA, allow your portfolio to grow on a tax-deferred basis, a major benefit when it comes to saving for your goals. Because taxes can significantly impact your portfolio's value, we generally recommend investing through accounts offering tax advantages.

Tax-advantaged accounts for retirement savers:

When it comes to saving for retirement, you have several account options that offer different tax benefits:

• With traditional retirement accounts, you may be able to deduct your contribution from your taxable income. This can leave you with more money to invest.
• Roth retirement accounts don't provide an up-front tax benefit, but their distributions are generally tax-free. This can give you additional flexibility to manage your taxes in retirement. If you're ineligible to make Roth IRA contributions due to your income, consider the backdoor Roth IRA strategy.
• While health savings accounts (HSAs) can be used for current healthcare expenses, saving these funds for retirement when healthcare costs are likely to be higher can be especially beneficial given their triple tax benefits.  
• If you're already maxing contributions to your employer plan, IRA, and HSA, consider making after-tax contributions to your employer plan or a non-qualified annuity to save beyond the regular contribution limits. You may even be able to convert your after-tax contributions to Roth assets through a mega backdoor Roth strategy.

Examples of tax-advantaged accounts¹

^{1 Refers to federal income tax.
2 You may have to meet certain requirements to be eligible to contribute.
3 No income taxes apply to traditional 401(k) contributions. Traditional IRA contributions may be deductible if your income is below a certain threshold.}

Tax-advantaged accounts for education savers:

For education savings, we generally recommend a 529 education savings plan. Although contributions are not deductible for federal income tax purposes, you may be eligible for a deduction from state income taxes depending on your state and the 529 plan you choose. And earnings and distributions used for qualified education expenses are generally tax-free. If the beneficiary doesn't need the money for college, you may be able to put the unused 529 funds to another use.

2. Own tax-efficient investments in your taxable accounts. 

Not all investments are taxed the same way. And, since your earnings in taxable accounts aren't tax deferred, we generally recommend getting your investment exposure in these accounts through more tax-efficient investments. Remember, though, that your overall asset allocation across all your accounts should align to your goals.

Avoid high-turnover mutual funds

Actively managed mutual funds can generate capital gains for you even if you don't sell shares because you're also taxed on gains generated by the fund manager. The more actively traded the portfolio, the greater the potential for capital gains. That's why we generally recommend gaining your equity exposure in taxable accounts through investments with lower turnover, such as exchange-traded funds; index, low-turnover or tax-managed mutual funds; or individual stocks. 

Consider municipal bonds and municipal bond funds

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, the higher your tax bracket, the more you may benefit from municipal bonds.

3. Make tax-smart trades within your taxable accounts.

While strong investment performance is a good problem to have, capital gains can lead to some unexpected surprises at tax time. Trading opportunistically within your taxable accounts can help lower current and future capital gains taxes.

Avoid short-term gains taxes

Long-term gains occur when you sell an investment you've held for more than a year and are taxed at your capital gains rate. Short-term gains occur when you sell an investment you've held for one year or less. They're taxed at your ordinary income tax rate, which is generally higher than your capital gains rate. 

If you own multiple lots of the same investment (i.e., the same security with different purchase dates and prices), sell those with losses first, then lots with long-term gains, and then lots with short-term gains when rebalancing your portfolio. While you generally shouldn't hold an investment simply to avoid taxes, it may even make sense to defer the sale of lots with short-term gains until they qualify as a long-term gain.

Consider tax-loss harvesting

Tax-loss harvesting is a strategy in which you sell a security at a loss to reduce capital gains taxes from other investments. For example, if you sell an investment with a $10,000 taxable gain, you may be able to sell another investment at a $10,000 loss to fully offset it.

To qualify, the investment must satisfy what's known as the wash-sale rule. The wash-sale rule states that a loss can't be claimed on a current-year tax return if a "substantially identical" security is purchased within 30 days before or after the sale resulting in the loss. This limitation applies across taxable and tax-advantaged accounts owned by you, your spouse, or certain entities you control. One way to potentially avoid a wash sale is to buy an exchange-traded fund (ETF) in the same sector or industry as the stock you sold so that you can maintain similar investment exposure until the wash-sale period has passed.

While tax loss harvesting can reduce your current-year tax bill, it's important to understand that it can also lead to larger capital gains in the future. 

Be aware of yearend mutual fund capital gains distributions

Mutual funds often pay a capital gains distribution near year-end. If you own shares of the mutual fund on what's called the record date, you'll receive the capital gains distribution and owe the taxes on it even if you've only owned the fund for a day. This means you could be paying taxes on gains you didn't participate in. 

Because of the potential for capital gains distributions, we generally recommend owning investments with lower turnover in your taxable accounts, such as ETFs, index or low-turnover mutual funds, and individual securities. If you're considering buying a mutual fund in a taxable account near year-end, though, you may want to wait until after the record date to avoid the capital gains distribution. Mutual funds publish their capital gains distributions in advance, typically in November or December, along with the record date and how much of the gain is short-term versus long-term.

If you already own mutual funds in your taxable account, pay close attention to the record date and amount of capital gains. In certain circumstances, it may make sense to exchange or sell your mutual fund shares to avoid the capital gains distribution, such as when you're holding the mutual fund at a loss or a much smaller gain than the capital gains distribution.

Want to give to charity?

Check out these charitable giving strategies for additional tax saving ideas.

Get expert input of tax strategies

Remember, every dollar you save in taxes is one more you can spend on what is most important to you, so managing taxes is an important part of your financial strategy. Whatever your goals and life stage, your financial advisor can partner with you and your tax professional to design an investing and tax management strategy to help meet your specific needs.

Tax-efficient investing FAQ

What does tax-efficiency mean when it comes to investing?

Tax-efficient investing seeks to minimize the tax impact on your portfolio. By minimizing taxes owed on investment accounts, you can also reinvest the money saved and compound your investment growth over time. 

What are the best tax-efficient investments?

We generally recommend investing in tax-advantaged accounts, such as traditional and Roth 401(k)s and IRAs, so that your investments can grow tax-deferred and, in some cases, tax-free. For investments held in taxable accounts, consider:

• Lower-turnover investments such as ETFs; index, low-turnover or tax-managed mutual funds; and individual securities.
• Municipal bonds and municipal bond funds for your fixed-income portion of your portfolio.

Keep in mind, though, that your overall asset allocation across all your accounts should align to your goals.

How do I start investing tax efficiently?

Reach out to an Edward Jones financial advisor today.