What is Tax Efficiency in a Portfolio Header ImageHaving a tax efficient portfolio simply means allocating your assets in a way that makes the most of tax rules and incentives.

Different investments generate different levels of taxable income, so by being strategic about what investments you make in which account, you can potentially save a lot of money.

Here’s what you need to know to get started.

The basics of tax efficient investing

Tax efficiency all starts with your accounts. Most people have access to three different kinds of investment accounts: taxable, tax-deferred, and tax-free.

Your standard brokerage account is a taxable account. Depending on your investment mix and performance, every April you’ll pay income taxes, capital gains, or a combination of both on any growth and dividends that you accrued throughout the previous year.

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Tax-deferred accounts grow tax-free until you take a distribution. Traditional IRAs, company 401(k)s, and non-profit 403(b)s are all tax-deferred.

You fund these accounts with pre-tax dollars from your paycheck or income so that money that would have gone to taxes today gets invested instead. You only pay taxes when you retire and/or eventually start taking distributions. At that point, you’ll pay ordinary income tax rates on any amount that you withdraw.

Tax-free accounts grow tax free and allow for tax-free distribution. Roth IRAs are the most common tax-free accounts: you pay taxes today on the income that you contribute, but after that you never have to worry about paying income taxes on distributions.

These accounts can be incredibly powerful, especially if you think your income will be higher in retirement than it is today.

Choosing the right strategy

Having trouble making a decision about which one to open? For many investors it can actually make sense to have all three types of accounts.

Diversifying across accounts provides the flexibility to draw retirement income from the account that makes the most sense at a given time, instead of locking yourself into a single type of income stream. It also gives you the ability to allocate your investments in the most tax efficient way.

However, rules relating to contribution limits and income – or just a simple preference to have a single type of account to deal with – can make one type of retirement account stand out from the others. Read more about choosing an IRA to learn more about individual retirement accounts.

Allocating your portfolio

Before focusing on making your portfolio more tax efficient, start with your big picture asset allocation.

Your overall portfolio allocation should be based on your risk tolerance, time horizon, and other factors unique to your situation, so it’s important to take a bird’s eye view across your accounts.

That way, you have more certainty as to where you’re investing and the confidence that you’re not missing anything. From here, you can start to distribute your investments strategically.

Taxes are triggered when you take dividend income or when you sell at a gain, so on the most basic level you want to put the investments with the most potential for triggering taxes in the most tax-efficient accounts. That means keeping high-dividend or actively managed assets in tax-advantaged accounts, and more tax-efficient assets in your regular brokerage account.

Higher-tax investments

For example, small cap stock mutual funds, which are composed of small publicly-traded companies, can sometimes be more volatile than large cap funds, which in turn can make them more likely to be bought and sold. As a result, you might end up paying a bit more in tax.

Similarly, actively managed mutual funds generate more taxable income than index funds because, by definition, they are bought and sold more often. These types of securities tend to make more sense in a tax-advantaged account like a 401(k) or IRA.

Of course, it’s important to note that taxable gains don’t make an asset class a bad investment: on the contrary, a well-diversified portfolio benefits from a mix of asset classes, and getting dividends or realizing gains can be very positive forces for a portfolio. Just remember to be strategic about where you put them!

Lower-tax investments

On the other hand, municipal bonds, tax-managed funds, and exchange-traded funds generate a relatively low level of taxable income and capital gains. These investments either enjoy preferential tax rates (in the case of municipal bonds) or their management structures keep taxes to a minimum.

Use these features to your benefit by considering them for your taxable accounts.

Also, keep in mind that if you have significant liquid assets, you may benefit from another option: a tax-deferred variable annuity. These annuities are typically best for those who are paying relatively high income taxes and need an additional tax shelter. Variable annuities can be a great financial tool for the right scenario, but they aren’t a good fit for everyone: be sure to speak to your advisor if you’re considering one.

Know thyself — and get help if you need it

Keeping an eye on the bigger picture of your allocation and choosing the right “home” for each investment can help you save costs and help give your portfolio more potential to grow over the long run.

But when it comes to tax management, it’s important to recognize that no two situations are alike.

While these rules of thumb can be useful, there are always exceptions — especially when you start to consider issues like estate planning and charitable contributions.

That’s why talking to an advisor can help. A good advisor should not only help you to focus on what’s important for your individual needs, but will proactively try to make the most of the tax benefits of each of your accounts.

However you build your portfolio, make sure that tax efficiency is part of your financial planning strategy. Making the time to allocate your portfolio strategically can help you save money today — which will also give you the chance to build more savings for tomorrow.

Are you a homeowner? Get more

Your home really can be a tax haven – if you know how to use it. Download our free guide and learn more about how you can make the most of homeownership, at least when it comes to Uncle Sam.

Download Your Home is a Tax Haven for free today! 

Free Download Your Home is a tax Haven

Learn More

You know that your home can be a powerful part of building wealth, but are you taking full advantage?

Download our free guide to the tax benefits of home ownership.

Let Us Help!

We can discuss this topic and more at a complimentary appointment. As a bay area retirement planning coaches, we can give you a review and make suggestions based on your retirement objectives.

Important Disclosures

The opinions voiced in this article are for general information only. They are not intended to provide specific advice or recommendations for any individual and do not constitute an endorsement by United Planners.

To determine which investments may be appropriate for you, consult with your financial professional. Please remember that investment decisions should be based on an individual’s goals, time horizon, and tolerance for risk. Neither diversification nor asset allocation can ensure a profit or prevention of loss in times of declining values. United Planners does not render tax advice.

Securities and advisory services offered through United Planners Financial Services, member FINRA, SIPC. Pasquale Vitucci, CA Insurance Lic. # 0758212, is an Endorsed Agent of Vitucci & Associates Insurance Services CA Insurance Lic. # 0I06319. Vitucci & Associates Insurance Services and United Planners are separate and unrelated companies.
This page contains links to third-party company websites. By selecting a link, you will be leaving our website and launching a new browser window. These links are provided for informational purposes only and should not be viewed as an endorsement, sponsorship, solicitation or other affiliation with respect to any third parties. We are not making any recommendations or providing any advice on securities in particular or investments in general. Neither Vitucci & Associates nor United Planners Financial Services have reviewed the content of, and are not responsible for, the information or the results of the third-party websites.

Further Reading

For more on different types of tax-advantaged retirement accounts, please visit https://www.irs.gov/retirement-plans/plan-sponsor/types-of-retirement-plans

Capital gains and losses: https://www.irs.gov/publications/p550

Municipal bond tax treatment: https://www.msrb.org/EducationCenter/Municipal-Market/About/Financial/Tax-Treatment.aspx