Tax Efficient Investing: How to Make Smart Tax Investing Choices

 Katrina Lamb, CFA writes: Taxes are an unavoidable part of our financial lives, and they influence the decisions we make about our spending, savings and investments. So when we’re planning our investment strategy for a long-term goal like retirement, how much weight should we give to taxes? In this post we’ll suggest some overall guidelines for tax efficient investing.

Tax Efficient Investments: Don’t Let the Tail Wag the Dog

“Don’t let the tail wag the dog” is perhaps the most important rule when it comes to investment strategy (the dog) and taxes (the tail).

The most important predictor of long-term investment success is diversification and asset allocation. Sometimes these decisions – such as reallocating funds from one asset class to another – can trigger taxable events. That’s okay. Let the investing strategy drive the decision. After that, minimize the tax consequences of that decision, to the greatest extent possible.

Don’t avoid rebalancing your portfolio in order to avoid taxes. Let the dog wag its tail … rather than vice versa.

What do we mean by “minimize the tax consequences”? Well, to take one simple example, the tax rate on short-term (less than one year) capital gains is generally higher than that on capital gains from assets held longer than one year. If you are planning on selling out of an asset that you have held less than a year and that has appreciated in price, it would make sense to defer the sale until you reach the 12 month mark, all else being equal.

On the flip side of capital gains, there are times when your portfolio will reflect losses from certain holdings, and these losses can (depending on your own situation) be used to reduce your overall tax liability. As the end of the year approaches, take a look at your portfolio, identify any opportunities for tax loss harvesting, and consult with your tax advisor on how to best implement this.

Tax Efficient Investing Within Your Mutual Funds

Some tax consequences of investing are out of your control. The choices that active money managers make, for example, is out of your hands. (Your decision to invest in actively-managed funds, however, is within your realm of control).

One useful metric for evaluating the possible tax consequences of investing in a certain fund is the turnover ratio. This measures the extent to which the holdings in a portfolio change (turn over) over the course of a defined period of time. A high turnover ratio can indicate the potential for high capital gains distributions.

Tax Efficient Investing in Retirement Accounts

It’s important to use tax-advantaged investment vehicles wherever possible. To that end you should take advantage of your annual 401(k) contributions to the maximum extent ($17,500 per year under current tax law), and also understand the advantages and restrictions on vehicles like Roth IRAs, 529 education plans etc.

Tax considerations should not be a primary driver of your investment strategy. But the dollars you can save by making intelligent tax choices wherever possible can add up considerably over time.