Q If you aren’t already doing so, take full advantage of the benefits of tax-advantaged accounts like 401(k) and individual retirement accounts (IRAs), including contributing the maximum allowable amount each year, ideally with matching funds from an employer. It’s also important to weight the tradeoffs of different account types.
Traditional 401(k)s and IRAs are funded with “pre-tax” dollars—meaning contributions aren’t subject to current taxes—and can potentially grow tax-deferred. However, withdrawals are taxed as ordinary income. Also, once you turn 73, you have to withdraw a certain amount each year, known as a required minimum distribution (RMD), which may bump you into a higher-than-desired tax bracket.
Roth accounts, on the other hand, are funded with “after-tax” dollars, but assets may grow tax-free and can be withdrawn tax-free, and there are no RMDs..
Invest in Stocks More Tax-Efficiently
If you’ve maxed out tax-advantaged retirement accounts or cannot use them due to restrictions or income limitations, there are other tax-efficient strategies to consider when investing in stocks, depending on how you prefer them to be managed:
Investors who prefer passively investing in equity indices like the S&P 500 may want to consider direct indexing. Here is how it works:
Instead of you buying an index-tracking fund, an investment manager establishes direct ownership of individual stocks that make up the chosen index through a separately managed account that you own.
This may allow you to take advantage of security-level opportunities for “tax-loss harvesting,” in which declining stocks are sold to offset potential gains in other investments held in your taxable accounts, potentially helping lower your tax bill. Such opportunities are generally not available with traditional index-tracking funds.
It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.” — George Soros
Investors can enhance tax efficiency across their entire portfolio by implementing strategies that consider the tax implications of each investment and the tax treatment of the account or vehicle in which they are held.
Actively Manage Investments
Active strategies may involve frequent buying and selling of stocks, often with a goal to beat a benchmark, but this high portfolio “turnover” can lead to more capital-gains taxes. Investing in active funds within an investment-only variable annuity (IOVA) or variable universal life (VUL) insurance policy may make sense. Both types of insurance vehicles include a tax-deferred investment account that, like in a traditional 401(k) or IRA, may defer the taxation of potential gains within the account until assets are withdrawn.
Withdrawals from an IOVA are taxed as income and can be taken penalty-free after age 59.5. VULs offer a death benefit that may help you hedge the risk of early mortality and/or achieve a more tax-efficient wealth transfer to beneficiaries; in addition, VULs may allow you to borrow against the cash value of the policy, or, if you are willing to realize taxable gains, withdraw from or liquidate the cash value of the policy subject to possible restrictions or surrender fees in certain circumstances.
There is no one-size-fits-all approach to tax-efficient investing. Every strategy comes with its own potential benefits and drawbacks. For many investors, the best options will be to seek out expert advice from professionals with access to sophisticated financial planning software and tools that can reflect your individual circumstances, preferences and needs.