Tax-aware investing: What is it and how do I do it?

Who doesn’t want to save on taxes, right?

The term tax-aware investing is used a lot, but what does it actually mean? As investors, it’s not just about how much your investments grow, it’s also about what you actually take home – and this is where tax-aware investing comes into play.

At its core, tax-aware investing can be broken into three categories:

Let’s break this down one by one.

What type of account – The house matters

One of the first decisions any investor makes is what type of account they want to use – think of this as the house you use for your investments. Most simplistically, these can be broken into accounts that are taxable and those that are tax-advantaged. Taxable accounts are just that – accounts where there are no built-in tax benefits.

Among tax-advantaged accounts, the most common types are generally those marked for specific uses like retirement (e.g., traditional IRAs, Roth IRAs and 401(k)s), education (e.g., 529 plans and Coverdell education savings accounts) and even charitable giving (e.g., donor-advised funds). The type of tax benefit will depend on the account type and most commonly include the deferral of taxes on contribution and/or the deferral of – or, in some cases, exemption from – taxes on the growth of the investments in the account. The trade-offs, however, are typically restrictions on access to the funds and/or use of the funds.

There are also more advanced and complex structures individuals can use, such as trusts and foundations, that might help address specific concerns or provide more custom solutions, but these will typically come with more legal and/or administrative costs.

Next, the furniture – What you buy matters

What comes next is what you put in those accounts. Different investments can have different tax implications. Corporate bonds, for example, generally accrue and pay interest, which is most frequently taxed at ordinary income rates (i.e., the same as income you receive from wages). However, dividends from many publicly traded stocks are taxed at long-term capital gains rates if you have held the stock for a required holding period and certain other requirements are met, which are typically lower than U.S. federal ordinary income tax rates.

Lastly, some investments like municipal bonds may offer natural tax advantages on the interest income they pay – interest from municipal bonds is typically exempt from U.S. federal income tax and can also be exempt from U.S. state and local income taxes depending on where you live and who issued the bond. Bond income that is exempt from U.S. federal, state and local taxes is sometimes called “triple tax-free.”

It’s also important to know that there might be tax differences depending on what type of investment vehicle you buy. For example, mutual funds tend to be less tax-efficient than exchange traded funds (ETFs). Mutual funds are generally more actively managed than exchange traded funds and may “turnover” and “rebalance” their investments more often than ETFs, which might result in taxable events for investors – even if the investor doesn’t have an overall gain in their shares of the mutual fund!

Lastly, the maintenance – The actions you take matter

How you invest or trade is as important as what you trade and where you trade. Two of the most common tax-aware actions are:

When you sell any investment at a gain, how long you own it impacts what tax rate is applied – gains on positions held a year or less are generally taxed at short-term capital gains rates, which are the same as your ordinary income rate. Gains on positions that you’ve held for more than one year, however, may be taxed at a lower long-term capital gains rate. Many investors take this into consideration when deciding when to trade.

The second common action is offsetting gains with losses, commonly referred to as tax-loss harvesting. Simply put, this involves offsetting realized gains by selling other investments at a loss within the same calendar year, then reinvesting the proceeds into similar investments to maintain exposure to the same industry. One thing to be careful of here is to not trigger a “wash sale” on the loss positions. For example, if you sell a stock at a loss and purchase the same stock (or any stock or security that’s considered “substantially identical” to the stock) within 30 days before or after the loss position’s sale date, the wash sale rule generally says you have to defer your loss.

Lastly, there are other actions you can take to be tax-efficient across your finances – for example, you can donate publicly traded stock (with long-term gains) to charities or a donor-advised fund, which may allow you to claim a charitable deduction for its fair market value without triggering capital gains taxes on the position. (Note: This strategy doesn’t work with stock held short-term or for stock with losses.)

Putting it all together

If you can, think about matching the furniture to the house. Investments with generally worse tax treatment – higher turnover and more short-term capital gains for stocks or bond investments with higher taxable interest payments – will often be better suited for a tax-advantaged account like a retirement account. Investments with reduced tax consequences – like certain qualified dividend-paying stocks or municipal bonds – may be better suited for a taxable account.

Similarly, your tax-advantaged house may need less maintenance than your taxable house – since gains generally aren’t recognized in a tax-advantaged account, you typically don’t need to spend time trying to offset gains in those accounts with losses. (But note, you can’t use your retirement accounts to get around the wash sale rule, either, by repurchasing securities there instead of in your taxable account.)

These are some general rules of thumb to help you think about where your own investing could be more efficient, but, as always, the details matter. For example, some specialized companies like real estate investment trusts (REITs) and master limited partnerships (MLPs) have different dividend tax treatments than what’s described above. It’s always a good idea to consult a tax professional and other investment professionals before making investment decisions.

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