What Is Tax-Efficient Investing?

Have you ever gone to visit your CPA at tax time and found out, at the very last minute that you’ve got a huge tax bill due to gains in your portfolio?  The most likely cause is that your financial advisor didn’t take into account the tax consequences of their portfolio moves, generating a large taxable gain.

The are two ways to combat this problem:  regular tax planning and tax-efficient investing.  Tax planning should be an ongoing conversation with your CPA to avoid having any nasty surprises come tax time.

Tax-efficient investing involves handling your investments to maximize the AFTER-TAX return.  It’s not how much you made, but how much you kept after taxes.  The following are some ways to reduce the tax burden on your accounts:

Hold Onto Your Investments

When you hold an investment less than a year, any gain is taxed just like your regular income.  By holding the investment for at least a year before selling, you reduce the tax rate to (currently ) 15%.  Timing the sale of specific investments to lower that tax rate is critical.

“Harvest” Your Losses

In the second half of the year, as you re-balance your portfolio, you should look to sell positions that have lost money so that loss can offset gains you may have elsewhere.  The idea is “harvest” losses equal to your gains in order to eliminate the taxes due.

Put The Right Investments In The Right Accounts

Use tax-efficient investments, like Exchange Traded Funds (ETF’s) in your taxable accounts and put the higher-tax investments in retirement accounts like IRA’s and 401(k)’s.  The overall effect is that you have, hopefully, reduced your overall tax burden.

On a final note, let me remind you that this blog entry is merely to illustrate the concept of tax-efficient investing and should not be construed to be giving tax advice.  Before undertaking any investment program, consult your wealth manager and CPA as each circumstance is unique.