Tax Efficient Investing: Tax Strategies to Save You Money

When it comes to managing your investments, one thing you want to be sure of is that you are using tax efficient investing strategies.  This is because taxes can eat into a large portion of your returns.  And who wants that?

Not all investment accounts are created equal though.  So by learning where you should hold certain investments you are able to minimize your tax burden and maximize your gains.

Here's a Quick Summary of Some Tax Efficient Investing Strategies:

Tax Efficient Investing: What is it?

Never knew there was a way to invest your money to save you on taxes, eh?  Well, me neither until just a few years ago.

Tax efficient investing is the act of investing in such a way as to minimize your taxes while maximizing your gains.  This is done by placing the right investments in the right investment accounts.

There are three kinds of investment accounts: Tax Deferred, Tax Free, and Taxable.  So if you want to implement tax efficient investing strategies, you should use these accounts to your advantage.  

That means those stocks and bonds that generate lots of tax liabilities you would put into your tax deferred or tax free accounts.  While those stocks or bonds that are more tax efficient you should place into your regular taxable brokerage account.

Why Should You Use Tax Efficient Investing?

There are 3 BIG reason why everyone should be using tax efficient investing strategies.

• It saves you money
• You build your wealth much faster
• It saves your heirs money

It Saves You Money

By investing your money efficiently you will naturally save yourself loads in taxes.  For instance, by holding onto your stocks for longer than a year, you can decrease your Capital Gains Tax significantly.

This is because stocks sold in the short term are subject to your ordinary income tax rate while those held longer than a year are taxed at much lower rates. (See tables below).

Capital Gains Tax Rates (Short-Term) = Income Tax Rate

You Build Your Wealth Faster

By engaging in tax efficient investing you are able to keep more of your money and reinvest it.  Thereby growing your wealth exponentially because the more you save, the more you can invest, and the faster your wealth will grow.

It Saves Your Heirs Money

Another plus of tax efficient investing is that when it comes time to hand off your wealth to your children you would be able to do so with minimal burden to them.

For example, when you invest in a Roth IRA (a tax free account because the money invested is already taxed), you can pass that on to your children and they won't have to pay taxes on it.

Furthermore, any asset you pass on to your child whether that be stocks/bonds or real estate is "stepped up" when it is given to your kids.  

This means that the gains that occurred while you held it is reset so that your children would inherit it at the current market value.  And should they choose to sell it immediately, they wouldn't incur any capital gains tax.

Tax Efficient Investment Accounts

When it comes to tax efficient investing, there are two investment accounts that are tax advantaged.  This means that these accounts provide you some tax benefits as opposed to a regular taxable brokerage account.

These tax advantaged accounts come in two forms: tax-deferred and tax-free.

Tax-Deferred Investment Accounts

These investment accounts provide you with the opportunity to save on taxes now.  Meaning you won't pay taxes on the amount you contribute to tax-deferred investment accounts.

Your money is allowed to grow tax free and only when you withdraw from the account will you be taxed on the money that you withdraw.

Examples of tax-deferred investment accounts include the 401k, traditional IRA (individual retirement account), and for Canadians the RRSP (registered retirement savings plan). 

Tax-deferred investment accounts are great to use when you want to lower your taxable income and pay less in taxes now.

Tax-Free Investment Accounts

These investment accounts allow you to withdraw your money at a later date completely tax free.  Essentially you pay taxes now so that you don't have to pay them later.

So although the money put into these accounts have already been taxed, that money is allowed to grow tax free and withdrawals are completely tax free.

Examples of these types of accounts are the Roth IRA, Roth 401k , and, for our Canadian friends, the tax free savings account.

Tax-free or tax-exempt investment accounts are great for anyone who plans to retire in a higher tax bracket than they are now.  

I also highly recommend these accounts because you never know what the future may hold and it is way better to have some tax free options in your bag that you can use should you need to in the future.

The Limitations of Tax-Advantaged Accounts

With all the amazing perks of investing in a tax-deferred or tax-free account, you may be wondering why would you invest in anything else.

Well, like with everything, there is a plus side and a downside.  One of the biggest downside to using these tax advantaged accounts is that you have limited control over your investment options.

And this is even more so when it comes to investing in 401k plans.  Your options depend on your companies plan which tend to be very limited, not very good, and have very high fees.

You can find more options with lower fees in traditional IRA accounts but what is lacking in both cases is flexibility.

When you use these tax advantaged accounts, you can't just take out your money when you want without being hit with early withdrawal penalties.  

So, you may want to consider having a taxable brokerage account in addition to your tax-advantaged accounts.

*One exception to the withdrawal penalty is for Roth IRAs.  You can withdraw your contributions without penalty but you have to wait 5 years before you can do so.

Order of Investments from Least Tax Efficient to Most Tax Efficient

Before you can get started investing efficiently you will need to know which investment options are tax efficient and which are not.  Below is a list of your investment options ranked from least tax efficient to most tax efficient.

How to Implement Tax Efficient Investing

Now that you know how each of the above assets relates in terms of their tax efficiencies, you may be wondering how you could use that information to benefit you.

Well, the first thing you will want to do is to make sure you put those assets that are not very tax efficient, like bonds, into a tax advantaged account such as an IRA or 401k.  

By doing that you won't be subject to all those tax liabilities that would arise if those assets had been in a taxable account.

Then those assets that are most tax efficient like municipal bonds, you'll want to place in your taxable brokerage account.  Because they are tax efficient, there will be little to no tax liabilities from them on a regular basis.

Other Tax Efficient Investing Strategies

Here are some other things to keep in mind if you want to minimize your taxes when investing in the stock market.

All in All

As you move along on your journey to building wealth, your income will increase as well as your net worth.  So as you and your money grow, you must look for ways to reduce your taxes and protect your wealth. 

Use some of these tips given here to help you protect your money better so that you have a legacy to leave to your kids.  As always do consult a certified financial advisor before making any decision.