Key Points to Remember
- Your tax bill can significantly impact how much money you actually keep from your investments over time.
- Place investments that generate more taxable income in retirement accounts, and keep tax-friendly investments in regular brokerage accounts.
- Managing taxes on investments can be complicated, so working with a financial advisor may be helpful.
When markets go up and down, it’s easy to focus only on whether your investments are making or losing money. However, taxes are another important factor that can reduce your investment returns over the long run. Money you don’t pay to the IRS stays in your account, where it can continue growing. Over many years, these tax savings can add up substantially and make a meaningful difference in your total wealth.
“Investors don’t have control over daily market movements,” explains Naveen Malwal, who manages investment portfolios at Strategic Advisers, LLC. “However, they can take deliberate actions to potentially improve their returns after taxes are paid.”
Managing your investments with taxes in mind requires thoughtful planning. You’ll need to think about when to buy and sell, which types of investments to own, where to hold them, and in what order to use your money. “Paying attention to taxes takes significant effort,” Malwal points out. “Working with a professional advisor could help you see real benefits.”
A smart tax approach starts with choosing the right investments based on when you’ll need the money and how much risk you can handle. From there, you can add specific techniques to help lower your tax burden. Here are 5 approaches worth considering.
1. Put Your Investments in the Right Accounts
Certain investments naturally create more taxable income than others through regular interest payments, dividends, or capital gains distributions. Common examples include:
Bonds and bond funds: Most bonds (except municipal bonds and certain savings bonds) produce interest that gets taxed at the same rate as your regular income.
Real estate investment trusts (REITs): These generate income and dividends that are taxed as ordinary income.
Actively traded stock funds: Fund managers who frequently buy and sell create taxable gains for investors.
Consider holding these tax-inefficient investments in retirement accounts like traditional IRAs or 401(k)s, where you can delay taxes until retirement when your income may be lower. Alternatively, use Roth IRAs or Roth 401(k)s, which let you withdraw contributions anytime and take out earnings tax-free in retirement if you meet the requirements.
2. Choose Tax-Friendly Investments for Taxable Accounts
For regular brokerage accounts, consider investments that create minimal taxable income, assuming they fit your overall financial plan:
Municipal bonds or ETFs: Interest from these is usually exempt from federal taxes and sometimes state taxes too.
Index funds and ETFs: Because these track market indexes and trade rarely, they typically produce less taxable income than actively managed funds.
Low-turnover active funds: Some fund managers naturally trade less often, making their funds more tax-efficient than others.
3. Time Your Investment Sales Wisely
Holding investments for more than one year provides significant tax advantages. Profits from investments sold within a year are taxed as ordinary income, with rates reaching up to 37%. However, profits from investments held longer than one year qualify for lower long-term capital gains rates (up to 20%, based on your income). High earners may also face an additional 3.8% Net Investment Income Tax on either type of gain, plus any state and local taxes. When selling investments in managed accounts with tax considerations, advisors look for holdings you’ve owned longer to benefit from these reduced rates, Malwal notes.
4. Plan Your Withdrawals Strategically
If you need to withdraw money from a taxable account, think about how it affects both your investment balance and tax situation. Selling investments you bought at low prices creates larger taxable gains. For retirement accounts, consider rebalancing after withdrawals since trades within these accounts don’t trigger capital gains taxes. Talk to a tax professional to find the withdrawal approach that works best for you.
5. Use Losses to Offset Gains
Market downturns create opportunities to reduce taxes on investment profits. You can use capital losses to cancel out taxable gains, and any remaining losses can offset up to $3,000 of regular income each year for individuals or married couples filing together ($1,500 for married filing separately). Unused losses can be carried forward indefinitely. “Looking for tax-loss harvesting opportunities throughout the year, not just in December, can be especially valuable as markets fluctuate,” Malwal says. “Investors who only review their portfolios quarterly or annually often miss earlier opportunities.” Be aware of wash-sale rules that can prevent the tax benefit if you’re not careful, Malwal warns. Consider getting guidance from a tax or financial professional.
The Bottom Line
Taxes can significantly reduce your investment returns over time, but smart planning can help you keep more of what you earn. Because these strategies involve complexity and require ongoing attention, working with a tax advisor or financial professional can help you find the best approach for your personal circumstances.
