Tax Efficient Investing

Tax Efficient Investing
Eileen St. Pierre, The Everyday Financial Planner

lowertaxes11[1]Many people do not realize how important it is to minimize taxes when investing. In other words, you need to create tax efficient portfolios. Here’s how to do it.


Identify which securities or investment funds generate taxable income.

These income sources are taxed as ordinary income:

  • Stock dividends (non-qualified)
  • Bond interest
  • Short-term capital gains – profit on securities sold within a year

It does not matter if you reinvest these cash flows – you still have to pay ordinary income tax in the year received.

How you do identify investment funds that generate high taxable income?

  • Funds labeled as “Income Funds” invest in stock and/or bonds that generate high dividend and/or interest income.
  • Look at the portfolio turnover % in the fund’s prospectus. A turnover rate of 100% means the entire portfolio is turned over or sold in one year. Anything higher than that will generate a lot of short-term capital gains. For example, a turnover rate of 400% means the entire portfolio is sold every quarter.
  • Funds with a high portfolio turnover tend to have higher management fees since the managers are so busy picking new securities to replace the portfolio. Whether or not they are good at it is another story.

If you decide you want to invest in these securities, they should be placed in tax-deferred or Roth retirement accounts.

The logic is simple.

  • By placing these securities in a tax-deferred account like a 401(k), you do not pay any income tax until you withdraw the money in retirement. So taxes on reinvested dividends, interest and short-term capital gains are deferred, allowing for faster growth in your portfolio.
  • If you place the securities in a Roth retirement account, you will never pay any tax on the reinvested dividends, interest, and capital gains.

Put high growth securities in taxable accounts.

Currently, long-term capital gains (securities sold for a profit after one year) are taxed at a lower rate than ordinary income. In 2015, the maximum tax rate on long-term capital gains is 20% versus 39.6% on ordinary income.

How do you identify investment funds that invest in securities that are expected to go up in value over the long-term? Look for funds labeled as “Growth Funds.” Many investment companies also have a “Tax-Managed” fund category that can be a good fit for taxable accounts.

Here’s the bottom line.

Minimizing taxes is just one factor in developing an investment strategy. You also need to consider your investment goals and relevant time horizon, along with your tolerance for risk. Finally, always make sure you understand the types of fees you are being charged to implement your investment strategy.