A guide to tax-friendly investing

A guide to tax-friendly investing

Group News posted in on 17 August 2017| comments
audience: The Boston Foundation | last updated: 17 August 2017
Structuring your investment portfolio to reduce your tax burden, commonly referred to as tax-efficient investing, can be a key driver of maximizing your investment returns. At the end of the day, it’s not just about how well your investments performed, but how well they performed after you paid the tax bill. By way of illustration, if your portfolio returned 10% for the year and you’re in the 25% marginal federal tax bracket, your effective rate of return would be reduced to around 7.5% after taxes. Over the long-run, taxes can be one of the biggest drags on your investment returns, but the good news is that efficiently managing your investment portfolio’s tax bite is one of the few aspects of investing that you can control. Here are a few simple strategies to help you do just that.
Location. Location. Location.
Most serious investors (at least those who have read this far) tend to hold at least two types of investment accounts: a tax-deferred retirement account (401(k) or IRA) and a taxable account you open through a brokerage firm. Some investors may even hold a post-tax account in the form of a Roth IRA or Roth 401(k). All of these accounts have their own advantages and disadvantages but as a general rule of thumb, income-producing investments (such as bonds) should be held in tax-deferred accounts, and tax-efficient investments (such as stocks) should be held in taxable accounts. For instance, most investors’ marginal federal income tax rate is in the 25%–39.6% range, while long-term capital gains are taxed at a top rate of 20%. Since bonds and bond funds tend to throw off much more taxable interest income than stocks, it follows that you should place bonds within tax-deferred accounts to avoid paying taxes on it. The diagram below will help you determine the most appropriate account type for your investments:

Where to invest….

Pre-Tax Account

Either Account

Taxable Account

High-Yield Bonds

Stock Trading Accounts


Taxable Bonds

Small-Cap Stocks

Index Funds

Real Estate/REITs

Mid-Cap Stocks

Tax-Managed Funds

High Turnover Funds

Large-Cap Stocks

I/EE Savings Bonds

Balanced Funds

International Stocks

Municipal Bonds

Consider holding tax-efficient mutual funds
These funds are known for their low tax liability and are great options for a taxable account. They typically have phrases such as “tax-managed,” “tax-free” or “tax-exempt” within their fund name. A fund manager can control taxes within the fund using a few different strategies:
1. By avoiding frequent trading and keeping the fund’s turnover low. Stocks held for more than one year are considered long-term holdings, and those capital gains are taxed favorably compared to those held less than one year.

2. Using tax gain/loss harvesting strategies by selling stocks with large capital losses to offset those with large capital gains, and then repurchasing after 31 days to avoid the wash-sale rule.

3. Investing in tax-free investments such as municipal bonds.

Avoid frequent trading
As I previously mentioned, frequent trading within a taxable account can generate short-term capital gains. Short-term capital gains are realized by selling an investment held for less than 365 days, and are taxed at the investor’s marginal income tax rate. Holding an investment for over a year can save you nearly 50% in taxes in the long-run (short-term vs. long-term tax rate), so absent a need or rationale for selling an investment earlier, it should be avoided when possible.

Be aware of mutual funds with large capital gain distributions
Most mutual funds wait until November or December to begin making capital gain distributions to their shareholders. These payments represent an investor’s share of the dividends, interest and gains earned by the fund, which the fund is now passing along to them. Mutual fund companies begin publishing their estimates near the end of the year. Although they’re only estimates, they are fairly accurate and can give you a good sense of the size of the distribution that’s coming. Dividing the distribution by the price of one share of the mutual fund (the NAV) can give you an idea of how large the distribution will be. Distributions larger than 10% should set off alarm bells and an investor should seriously consider selling the fund before the “ex-date” (i.e., if you own the investment on or before the “ex-date,” you are entitled to the distribution). The distribution is usually paid out a few days after the “ex-date.”

Additionally, researching future capital gains distributions should be part of an investor’s screening process when looking to purchase a new mutual fund. Waiting to purchase a mutual fund until after the distribution date can also help avoid having to pay a lot of unnecessary taxes.

Investing in ETFs (exchange-traded funds) is an excellent choice for investors who are concerned about taxes and do not have the time to research capital gain distributions. ETFs typically do not distribute much in the way of capital gains. Basic index ETFs can also be very low cost and are great tools for gaining diversified exposure to the stock market.

Paying taxes is inevitable, but using a combination of these strategies to minimize and defer (or avoid) them can have a large impact on the long-term return of your investment portfolio. Investors should not make investment choices solely based on tax issues, but the tax consequences should always be considered with your investment planning.

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