Create a tax-Efficient Investment Plan With These Tips

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High investment costs are the most reliable predictor of poor investment performance, and investment taxes are often the largest component of such costs. Left unchecked, the performance drag due to taxes can compound to substantial amounts.

While you can’t eliminate taxes, there is some good news for investors: the effect of taxes on performance is largely under your control. A few principles when selecting your investments can go a long way in reducing the tax drag and increase the efficiency of your savings over time.

The goal of tax efficient investing

The goal of tax-efficient investing is not simply to minimize taxes. A zero investment return has no tax bill, but it is hardly a desirable investment. Actions that reduce tax today may increase taxes in future years, and not necessarily produce the best outcome for your goals. Similarly, picking investments based on their potential pre-tax return may not produce the best return, after taxes.

The key to tax efficient investing is to make tax considerations an integral part of the selection and ongoing management of your investments. What matters for your plan is the total, net-of-tax performance of a portfolio relative to your goals, horizon, and risk preferences. The goal should be to increase the total, net of tax wealth for your goals or to minimize the amount you need to save to reach your goals. (With the understanding that both these objectives should be subject to risk constraints.) This means that you need to consider taxes at all stages of your financial plan. From selecting and prioritizing your goals to the ongoing management of your investments.

Goal Selection and Prioritization

Clearly identifying and prioritizing goals should be the first step in any investment plan. Your goals help you select the appropriate level of risk given your financial situation, and how to direct your future savings. Clearly identified goals and carefully planned contributions can help you select the types of accounts that are best suited for your needs. For example, accounts like your 401(k) or IRAs are good options to save for retirement in a tax-efficient manner. The choice between tax-deferred (traditional) or tax-exempt (Roth) accounts depends on the trajectory and variability of your income, and we have discussed it here. Similarly, if college planning is a priority, a 529 plan is a tax-efficient way to save for higher education. 

Select Tax Efficient Investment Options

Most investors invest in stocks and bonds through traditional mutual funds and exchange-traded funds, or ETFs. Properly chosen, these can be very efficient investments. Typically, low cost, broad based funds that do not trade often can be very efficient. Index funds are mutual funds or ETFs that replicate the holdings (and performance) of an index of stocks or bonds. An index is a selection of stocks in a particular market or market segment. For example, the S&P 500 includes the largest 500 companies in the US. Because these large companies comprise over 80% of the US stock market, it is a broad index. There are, however, even broader indexes, covering the US market, international markets, or both. 

Generally, broad index funds do not trade often and are tax-efficient. In addition, their relative popularity means that the funds can use periodic contributions to rebalance, instead of realizing taxable gains. Beware of index funds with a  narrow focus and few companies in them, as these may not be very efficient investments. Plus the narrower the investments you hold, the more likely you are to rebalance across the funds that you hold. A good principle is to hold as few funds as possible when creating a broadly diversified portfolio. Typically 2-3 equity funds and a similar number of bond funds should suffice.

In addition or as an alternative, there are also broad-based and tax efficient investment options among non-index funds (see for example Dimensional Fund Advisors or Avantis Investors). These fund families offer broad based investment options that have additional flexibility relative to index funds, and can be even more efficient.

Consider Tax Advantaged and Muni Bond Funds

If you are in the highest tax brackets and are particularly sensitive to taxes, you can consider tax-managed or tax-advantaged funds. These funds are managed with taxable accounts in mind. While the actual strategies vary across funds, these funds typically avoid short term gains, which are typically taxed at a higher rate than long term gains, and employ tax loss harvesting or TLH. The latter is the sale of investments at a loss in a portfolio to offset gains in other parts of the portfolio.

Municipal bonds (or muni bonds) are bonds issued by states, cities, and local governments. There are mutual funds and ETFs that invest in muni bonds within particular states or across multiple states. Income from muni bonds is generally free from federal taxes (although you may realize some capital gains from these funds).  Because of this feature, muni bonds are often called “tax-exempt bonds.” Municipal bond income is also usually free from state tax in the state where the bond was issued.

Because of the special tax treatment, these bonds generally give you lower interest rates than comparable taxable bonds.

Limit Trading and Practice Smart Rebalancing

The next step is to make sure you have a plan and a portfolio that you can stick with and does not create the need to make changes. There are typically two reasons for unnecessary changes. The first is behavioral. If you pick active strategies that you expect to outperform, your emotions may lead you to make changes when they don’t. And any change can be costly from a tax perspective. Another reason for frequent trading can be the selection of narrow indexes, which can lead to more frequent rebalancing. You can substantially reduce trading by choosing broadly diversified and passive strategies consistent with your long term goals.

Once you establish a long-term portfolio strategy, you should monitor your portfolio at regular intervals and after large market changes. Compare how much you are invested across the different funds vs. your ideal portfolio. Allow for some slack but be ready to rebalance towards your targets if the deviations are too large. A tax efficient way to rebalance is to consider your contributions to your investments. If you need to rebalance and know you are making a contribution soon, use that contribution to invest more heavily in underrepresented investments. Similarly, if you are withdrawing from your accounts, consider rebalancing needs as you withdraw from the different funds. 

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As you can see, tax considerations should be integral to the investment process, from the setting of your goals to the ongoing management of your portfolio. For some investors, more advanced tax considerations, including tax loss harvesting and tax location can be important. However, going through these suggestions can greatly improve the tax efficiency of most investors.

Until Next Time!

Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC.  DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives.  As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.