Tax-aware investment strategies you should consider

Text size: aA aA aA
A bar graph superimposed on top of a tax return.
Although taxes shouldn't necessarily drive your investment decisions, thoughtfully evaluating the asset classes you choose and the accounts you hold them in could help you lower your tax bill.
While tax rules and rates may change over time, the value of keeping taxes in mind when making investment decisions does not. The reason? Taxes can reduce your investment returns from year to year, potentially jeopardizing your long-term goals.
Before you decide on the percentage of stocks, bonds and cash instruments that make the most sense for you, it's helpful to understand how the IRS treats the income from those asset classes. Ordinary income, including from interest payments on bonds and cash, is currently taxed at individual rates as high as 37%, plus an additional 3.8% if the net investment income tax applies. Profits from the sale of stocks you've held for more than a year qualify as long-term capital gains, and the long-term capital gains tax rate currently maxes out at 20%, plus the potential 3.8% net investment income tax. Also, be aware that if you hold a stock for one year or less and sell it at a profit, the gain will be taxed at your ordinary income rate, which could be considerably more than the capital gains rate. (It's worth noting that future tax law changes are always a possibility.) State and local taxes may also apply.
The higher your current income tax rate, the more beneficial it may be for you to consider the impact of taxes when making changes to your investments. Be sure to consult with your professional tax advisor before making any decisions that could affect your taxes.
Here are six strategies that can help maximize your tax efficiency.

1. Contribute to tax-efficient accounts

Take advantage of tax-efficient retirement accounts for which you're eligible to help reduce current and/or future taxes.
Current income tax impact
  • Traditional IRA contributions may be federally tax deductible
    • Your total annual contribution to traditional IRAs is subject to a dollar limit
    • Your deductible contribution to a traditional IRA may be limited if you (or in some cases your spouse) are an active participant in an employer-sponsored retirement plan, such as a 401(k), and your income exceeds certain thresholds
  • Your 401(k) employee contributions can be made pre-tax, reducing your current federal taxable income, and are subject to annual contribution limits
  • Roth IRA and Roth 401(k) employee contributions are made on an after-tax basis and are subject to annual contribution limits. Roth IRA contributions may be limited depending on your income level. Roth 401(k) contributions may or may not be available depending on the terms of your employer's plan.
Future income tax impact
  • Traditional IRAs and pre-tax 401(k) contributions offer federal tax-deferred growth potential
  • Roth IRAs and Roth 401(k) contributions offer federal tax-free growth potential

2. Diversify your account types

Using a combination of investment account types lets you mix and match income sources in retirement to help potentially minimize your taxes.
Different investment account types offer different tax treatments
  • Traditional IRAs and pre-tax 401(k) contributions offer federal tax-deferred growth potential
  • Roth IRAs and Roth 401(k) contributions offer the potential for growth that won't be federally taxed if account owners meet requirements for qualified distributions (state taxes may apply)
  • Brokerage accounts offer taxable growth potential
Here are some examples of how diversifying can benefit your investments
  • If you are eligible to take tax deductions in retirement, you'll need taxable income in order to take advantage of them. Withdrawals from a traditional IRA or pre-tax 401(k) count as taxable income, so you could withdraw only enough to offset your eligible deductions and then draw the rest from your Roth account. Qualified distributions from Roth accounts are federally tax-free (and may be state tax-free).
  • If you have taxable accounts to draw from in retirement, you can draw them down and allow your traditional IRA and pre-tax 401(k) assets to continue to potentially grow tax deferred until your required beginning date after which time minimum distributions must be taken.
  • Money contributed to a traditional IRA or 401(k) on a tax-deductible or pre-tax basis is taxed upon withdrawal at your future tax rate, which may be lower than your current rate. In contrast, money contributed to a Roth IRA or Roth account 401(k) plan is taxed at current federal rates, and qualified distributions are federally tax-free and also may be exempt from state tax.
Spreading your contributions among different account types may help you reduce your taxes in retirement, whether your future tax rates will be higher or lower than they are now, if you take steps ahead of time to establish different account types for tax diversification. It's often wise to leave as much as you can in your retirement accounts as long as you can so those investments can continue to grow on a tax-free or tax-deferred basis. As long as you're working, you generally don't need to take required minimum distributionsFootnote 1 (RMDs) from your non-Roth qualified retirement plan accounts, such as a pre-tax 401(k), unless you're a 5% owner of the business sponsoring the plan. If your retirement plan account is a traditional IRA, you must begin taking RMDs by the required age, regardless of whether you are still employed.
Tax-efficient investing shouldn't supersede your existing investment strategy, but it is important to consider with your tax advisor when you're making investment decisions.

3. Choose tax-efficient investments

Specific investments can carry tax benefits as well. For instance, income earned from municipal bonds is generally income tax-free at the federal level and, in some cases, at the state and local levels too. Be aware that tax-exempt bond income is usually tax exempt when it's held directly, but when it's distributed from a retirement account — unless it is a qualified distribution from a Roth account, generally — it's treated as ordinary income and is taxable.
Other tax-aware investments may include tax-managed mutual funds, whose managers work deliberately and actively for tax efficiency, as well as index funds and exchange-traded funds that passively track long-term investments in a target index. It's important to check with your tax advisor to make sure you understand the tax features of these investments and to determine whether municipal bonds, which often have a lower yield than other bond options, may be an appropriate choice for your nonretirement account portfolio.

4. Match investments with the right account type

It's important to make sure you're taking full advantage of tax-efficient investments by holding them in accounts with the most advantageous tax treatment. Investing in this way can help ensure that you're realizing all potential tax benefits without increasing your tax liability.
  • Investments that regularly generate taxable income, such as taxable bonds or stock funds with high turnover, may be better held in tax-deferred accounts — traditional IRAs, for instance — to gain the best potential tax benefit. Note that withdrawals you take during retirement may be taxed at your ordinary income rate, which may be lower at that time — or potentially not taxed at all in the case of a Roth account.
  • Tax-neutral investments, such as tax-managed mutual funds and municipal bonds, are generally better suited for a non-tax-deferred account, like a taxable brokerage account. The reason? If your investments don't generate high taxes, there is less of a need to defer them, so there is little reason to put them in an account that could restrict your access to them.
Just be sure that the decisions you make about where to hold various investments are consistent with your overall financial strategy.

5. Hold investments longer to avoid unnecessary capital gains

It is rarely worth holding on to a stock you are ready to sell simply to avoid taxes — with one exception. While gains recognized on stocks held for a year or less are taxed at federal ordinary income rates, gains recognized on stocks held longer than a year are taxed at the federal long-term capital gains rate — currently 15% for most investors and 20% for high-income taxpayers, plus the potential 3.8% net investment income tax. As a result, it may make sense to delay selling appreciated stocks until they qualify for long-term capital gains treatment. Again, always check with your tax advisors.

6. Harvest losses to offset gains

Using any investment losses you may have to offset your investment gains each year — a technique called tax-loss harvesting — can help reduce your federal income tax liability. And, if your investment losses exceed your gains, you can use them to offset up to $3,000 of federal taxable income each year as well, with additional losses carried forward to future tax years. For higher earning investors, a higher long-term capital gains tax rate plus a potential additional net investment income tax of 3.8% can make tax-loss harvesting even more valuable. Bear in mind that if you wait until late in the year to sell, you'll be dependent on what happens in the markets in the year's final weeks. And if you buy substantially similar stocks within 30 days before or after the sale, it will be considered a wash sale, and you may not be allowed to subtract those losses from your gains for that taxable year. Consult your tax advisor to ensure that the wash sale rules won't prevent you from using this strategy.
Whatever strategies you use, remember that tax efficiency isn't the only consideration for your investment decisions. You also need to think about how each investment can help you pursue your diversification, liquidity and overall investment goals — at a level of risk you are comfortable with. Tax efficiency then becomes another way to help you choose among your investment options. Be sure to consult with your professional tax advisor before making decisions that will affect your taxes.
With each of the strategies described above, you should consider the impact of state and local taxes in addition to the impact of federal taxes.
Next steps

Footnote 1 Effective Jan. 1, 2023, the required beginning date is April 1 of the year after you turn age 73. You are required to take an RMD by Dec. 31 each year after that. If you delay your first RMD until April 1 in the year after you turn 73, you will be required to take two RMDs in that year. You may be subject to additional taxes if RMDs are missed. Please see your tax advisor regarding your specific situation.

Investing involves risk. There is always the potential of losing money when you invest in securities.

Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa.

Income from investing in municipal bonds is generally exempt from federal income tax and state taxes for residents of the issuing state. While the interest income is generally federal income tax exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the federal alternative minimum tax (AMT).

The investments discussed have varying degrees of risk. Some of the risks involved with equity securities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks.

Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.