Like any competitive endeavor, investing involves high-profile actions and subtle strategies. Among the most impactful, yet often overlooked, is tax efficiency. This crucial factor can significantly enhance returns without increasing risk. While taxes shouldn’t be the primary driver of your investment decisions, strategically selecting asset classes and account types can substantially reduce your tax burden.

A Merril Lynch article explains that tax rules and rates may change over time, but the importance of tax-aware investing remains constant. The reason is straightforward: Taxes can steadily erode your investment returns year after year, potentially undermining your progress toward long-term financial goals.

Key Considerations

• Choose appropriate account types for different investments
• Understand how various asset classes are taxed
• Maintain a long-term perspective that balances tax efficiency with overall investment strategy

Every investment decision—from buying and selling to managing capital gains and planning for retirement—carries tax implications that can profoundly affect your long-term financial security.

Navigating the complexities of tax-efficient investing can be time-consuming and overwhelming, diverting your attention from other life priorities. Partnering with a professional CPA or financial advisor can streamline this process, optimize your returns, and free up your valuable time. Here are some common strategies an advisor can implement to enhance your wealth journey:  

1 Maximize Tax-Advantaged Retirement Accounts

Contribute to tax-deferred accounts like traditional IRAs and 401(k)s using pre-tax income to reduce your current taxable income. Your investments grow tax-free until retirement withdrawals, which are then taxed as ordinary income. This strategy benefits those expecting lower tax brackets in retirement.

Consider Roth IRAs as well, which accept after-tax contributions but potentially offer tax-free withdrawals in retirement. Depending on your situation and contribution limits, you may qualify to fund multiple accounts simultaneously—401(k), traditional IRA, and Roth IRA

2 Hold Investments Long-Term: Capital Gains Tax Strategy

Before determining the right allocation of stocks, bonds, and cash instruments for your portfolio, it’s important to understand how the IRS taxes income from these assets. Ordinary income—such as interest from bonds and cash holdings—is taxed at individual rates of up to 37%, with an additional 3.8% if the net investment income tax applies.

In contrast, profits from selling stocks held for more than a year qualify as long-term capital gains, which are taxed at a maximum rate of 20%, plus the potential 3.8% net investment income tax. However, if you sell a stock after holding it for one year or less, any profit is taxed at your ordinary income rate, which may be significantly higher than the capital gains rate. The holding period of your investments directly impacts the tax rate applied to capital gains. Before selling taxable assets, understand these two key capital gains categories:

Short-Term Capital Gains

• Apply to profits from investments held less than one year
• Taxed at your ordinary income tax rate
• Tax rates range from 10% to 37%, depending on your tax bracket

Long-Term Capital Gains

• Apply to profits from investments held more than one year
• Taxed at significantly lower rates based on income
• Tax rates are 0%, 15%, or 20%
• According to the IRS, most taxpayers qualify for the 15% or lower brackets

Example (2024)

For a single filer with $195,000 taxable income and a $2,000 capital gain:

Long-term scenario (held > 1 year)

• Tax rate: 15%
• Tax bill: $300

Short-term scenario (held < 1 year)

• Tax rate: 32% (marginal income tax rate)
• Tax bill: $640

Special Consideration for High-Net-Worth Individuals

The Ultra-High-Income Tax (UHIT) adds complexity to capital gains tax management. If your income exceeds certain thresholds, you may face higher capital gains tax rates, which can significantly impact your investment returns.

3 Utilize Tax-Loss Harvesting

Tax-loss harvesting is one of the more technical maneuvers allowed in the U.S. Tax Code. This strategy lets you reduce your taxable capital gains by offsetting them with capital losses.

How It Works

• When you sell investments at a loss, you can use those losses to offset capital gains from other investments
• Example: If you realize $10,000 in gains but also sell an investment at a $5,000 loss, your taxable gain would be reduced to $5,000

Additional Benefits

• If your capital losses exceed your capital gains in a given year, you can deduct up to $3,000 in net capital losses against your ordinary income
• Any unused losses beyond the $3,000 limit can be carried forward to future tax years
• This effectively allows you to “roll over” the additional tax relief

Potential Impact

• Tax-loss harvesting is a powerful strategy that can significantly increase the after-tax value of an equity investment portfolio
• An academic research study has estimated the benefits to be approximately an additional 1.10% in after-tax returns annually

Strategic Considerations

• This technique can help lower your overall tax liability while simultaneously allowing you to optimize your investment portfolio
• It is most effective when incorporated into a comprehensive tax and investment strategy 

4 Reinvest Your Dividends

Dividend reinvestment redirects dividends earned from stocks or mutual funds back into purchasing additional shares of the same investment instead of taking cash payouts. Many brokerages offer automated Dividend Reinvestment Plans (DRIPs) for this purpose. While this strategy accelerates long-term growth through compounding, remember that dividends are taxable in the year they’re earned—whether you take them as cash or reinvest them.    

5 Donate Appreciated Assets to Charity

Donating appreciated assets to charity offers dual tax benefits: you avoid capital gains tax while potentially claiming a charitable deduction. Consider using a Donor-Advised Fund (DAF), which allows you to contribute assets, receive an immediate tax benefit, and direct grants to your preferred charities over time.

Conclusion

It’s also important to consider that tax laws may change, and state and local taxes could further impact your returns. If you’re in a higher tax bracket, factoring in tax implications when adjusting your investments can be particularly beneficial.