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You’re likely to hear a lot of talk about “tax-efficient investing” — but what exactly does that mean?

Tax-efficient investing means using strategies that can help with after-tax wealth accumulation, instead of solely trying to minimize taxes.

In other words, it’s about what you keep after taxes. You can pay no taxes by having no money, but that is neither practical nor ideal.

Taxes matter when it comes to evaluating the overall performance of your investments. They also add a layer of complexity to investing because your investment and tax strategies should be tailored to your personal circumstances. Generalities and rules of thumb can only do so much when there’s a lot to consider: income tax bracket, state of residence, marital status, how often a mutual fund distributes capital gains, your investment style, the types of accounts in your portfolio, etc.

In his book The Intelligent Portfolio, Christopher Jones, Financial Engines’ chief investment officer, outlines six key principles for pursuing a tax-efficient investment strategy:

1. Reduce the impact of taxes on after-tax returns by paying lower tax rates and deferring taxes into the future when possible.

2. Avoid paying high taxes on taxable distributions when possible.

3. Be smart about holding different kinds of assets. For example, equity funds are generally more tax-efficient than bond funds (except municipal bonds).

4. Hold assets that are less tax-efficient in a tax-deferred account (such as an IRA or 401(k)) and assets that are more tax-efficient in a taxable account (like a brokerage account).

5. Avoid equity mutual funds with large short-term capital gains distributions. Equity funds with high turnover (more than 100% per year) are particularly likely to distribute short-term capital gains. Index funds are typically more tax-efficient.

6. If you are in a high-income tax bracket, consider municipal bonds for your fixed income holdings in taxable accounts. Never hold municipal bonds in a tax-deferred account like an IRA, and low-income investors should generally avoid municipal bonds.

It’s no secret that this is complex information requiring a lot of coordination. Investors can put tax strategies in place on their own. However, with so many variables to think about, particularly if a large portion of your investable assets are held in taxable accounts, it often makes sense to consult a qualified investment advisor or tax expert.

Historically, that level of personal service was commonly reserved for high net worth individuals — but today’s technology and new services have opened the door for investors from all income ranges to build a tax-efficient investment strategy with professional help. Financial Engines offers investment advice that can help many of our clients take full advantage of opportunities designed to help save money and accumulate wealth over the long-term.

Taxes are something on most people’s mind throughout the year. Having an understanding of how your accounts will be taxed can help you put a strategy in place that keeps your money working for you.

 

This post is based on Chapter 11 from the book The Intelligent Portfolio, by Christopher Jones, Financial Engines’ chief investment officer. While the content has been revised for the purposes of this blog, the ideas, information and some language remain intact.
Jones, C. L. (2008). The Intelligent Portfolio. Hoboken, New Jersey: Wiley & Sons, Inc.
©2018 Financial Engines, Inc. All rights reserved. Financial Engines® is a registered trademark of Financial Engines, Inc. All advisory services are provided by Financial Engines Advisors L.L.C. or its affiliates. Financial Engines does not guarantee results and past performance is no guarantee of future results.
The information provided is general in nature, is for informational purposes only, and should not be construed as legal or tax advice. Financial Engines does not provide legal or tax advice. Financial Engines cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws which may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Financial Engines makes no warranties with regard to such information or results obtained by its use. Financial Engines disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.
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