How to make the most of your savings using a tax-efficient approach

Taxes can create a drag on your investment performance, but through smart choices and a tax‑wise strategy, you can reduce that impact. The goal of these efforts is not to eliminate taxes but to minimize their influence on your returns.

The importance of taxes in your investment strategy will depend on your situation, including your tax rate. The higher your marginal tax rate, the more value there is in pursuing an investment strategy that factors taxes into your decision‑making process. Even so, many of the strategies described below could be options for investors in most tax brackets. That is particularly true when it comes to saving in tax‑advantaged accounts and diversifying your account types.

Contributing to tax‑advantaged accounts

Contributing to tax‑advantaged accounts is one of the simplest and most accessible ways investors can be more tax savvy. Retirement savings accounts allow your investments to grow without the annual drag of taxes on interest, dividends, or realized capital gains. Making tax‑deferred contributions to some retirement accounts, including Traditional individual retirement accounts (IRAs) and 401(k) plans, reduces your taxable income. Roth contributions are not deductible, but qualified distributions are tax‑free.

Since tax rates on both ordinary income and long‑term capital gains have decreased in recent years, investors might wonder if a taxable account would be preferable to a tax‑advantaged account. Over a long time horizon, the short answer is no. A Roth account is almost always preferable to a taxable account, given the former’s qualified tax‑free withdrawals. A Roth account is also generally preferable to a tax‑deferred account if your tax rate will be higher in retirement. If your tax rate will stay the same or decrease in retirement, a tax‑deferred account works out better than a taxable account. (See Scenarios 1 and 2.)

The advantage of tax-deferred accounts
Tax‑deferred accounts provide an important foundation for many individuals’ retirement savings plans. The examples below compare the ending after‑tax value of a $10,000 tax‑deferred contribution and an equivalent investment in a taxable account. In both scenarios, tax‑deferred is better for growing savings over time—and the longer the time horizon, the bigger the improvement.

Diversifying your account types

Tax‑advantaged accounts form an important foundation for your retirement savings, but taxable accounts can provide flexibility for other goals and for savings above annual retirement plan contribution limits. Setting aside money in different types of accounts offers flexibility for your withdrawals in retirement, allowing you to better manage your tax liability.

The different account types can include taxable accounts, tax‑deferred accounts, and Roth accounts. Health Savings Accounts (HSAs) are also an investment option for those with high‑deductible health plans (HDHPs) who have the ability to set that money aside over a longer time horizon to cover future medical expenses. Each account type has different tax treatments and, thus, different ways it can fit into an income plan for retirement. (See “Tax treatments of different accounts.”)

Choosing tax‑efficient investments

Some investments carry their own intrinsic tax benefits. For example, interest income from certain municipal bonds is tax‑free at the federal level and potentially at the state and local levels as well. Similarly, investing in exchange-traded funds (ETFs) can help reduce taxable distributions and improve after-tax returns.

When comparing investments, it’s important to focus on after-tax returns rather than pretax performance alone. For example, a lower yield on a tax-free municipal bond may be preferable to the yield of a comparable taxable bond because more of that income stays in your pocket. In fact, the higher your marginal tax rate, the higher the pretax yield on a taxable bond would need to be to match the after-tax yield on a municipal bond. (See “A look at tax-equivalent yields.”)

The same principle applies when evaluating stock funds. Both mutual funds and ETFs may distribute net realized capital gains to shareholders. However, because ETFs generally minimize sales within the portfolio, capital gain distributions tend to be lower, allowing investors greater control over when they realize taxable gains. While ETFs can provide distinct tax advantages in taxable accounts, those benefits generally apply only to capital gains. Dividends from stock ETFs and interest from bond ETFs are still distributed to shareholders and are generally taxable. (See “Consider the tax efficiency of ETFs.”)

Consider the tax efficiency of ETFs
Exchange-traded funds (ETFs) can offer an important tax advantage for long-term investors in taxable accounts. Because ETFs generally use an in-kind creation and redemption process, they historically have distributed few or no capital gains to shareholders who remain invested.¹ This can provide peace of mind for investors who would prefer that their year‑to‑year tax liabilities are driven less by the trading activity of other shareholders and more by when they choose to sell and realize their gains. While no investment can eliminate taxes, ETFs can be an attractive option for taxable investors seeking diversification, long-term growth, and greater control over capital gain realization.

Pay attention to asset location

Where you hold your securities is also an important component of a tax‑savvy strategy. Generally, investors should aim to hold investments that generate significant ordinary income in tax‑advantaged accounts. For instance, high‑yielding taxable bonds and bond funds, as well as real estate investment trusts, should generally be held in tax‑deferred accounts. Depending on your situation, even stocks or stock funds that generate qualified dividends might be better in those accounts than in taxable accounts.

Additionally, consider the benefits of using Roth accounts to hold securities that have potential for significant long‑term growth. It could make sense to put very high‑growth‑potential securities in Roth accounts if you plan to hold on to them for a long time, since that growth will be tax‑free. A Roth account can be a particularly good choice for high‑turnover growth strategies in your portfolio, since those could generate short‑term capital gains in a taxable account.

By comparison, more tax‑efficient or tax‑advantaged investments should be held in taxable accounts. Municipal bonds, for instance, should only go in taxable accounts, as their tax benefits are wasted when held in a tax‑advantaged account. Stocks, stock ETFs, and low-turnover equity funds held longer than one year currently receive preferential capital gains tax treatment compared with short‑term gains or ordinary income, so these, too, can be appropriate for taxable accounts.

In any event, keep in mind that if you have assets in a taxable account, you should focus on their after-tax returns and the level of control you have over capital gains realization. Implementing the specifics of a location strategy will depend on your mix of accounts and asset allocation. In addition, exceptions to these general rules are appropriate when taking your time horizon into consideration. (See “Balancing tax efficiency and time horizon.”)

Balancing tax efficiency and time horizon
There are times when holding less tax‑efficient securities in a taxable account makes sense. When it comes to short‑term goals, such as saving for a down payment on a home, it can make sense to hold more conservative investments, such as short‑term bond funds, in a taxable account. Doing so ensures that those assets are available to you, penalty‑free, when it’s time to withdraw them. Holding those assets in a tax‑advantaged fund might lead to withdrawal penalties if your goal arrives before you reach the age of 59½. Don’t let the taxes play the dominant role in your decision about where to hold various investments. To the extent that you have short‑term goals, it’s ok to hold conservative interest‑generating investments in a taxable account to have those assets accessible when you need them.

Stay focused on what’s important

Ultimately, the most important elements of your retirement savings plan involve how much you save and how early you can start saving. Seeking tax efficiency should never get in the way of maximizing your savings, but a few relatively easy steps can go a long way toward tax efficiency. While avoiding all taxes is virtually impossible, investors can make some important portfolio decisions and adjustments to adopt a more tax‑efficient investing strategy.