Tax-efficient investing strategies

Investing can provide additional income and can be a smart way to build up your retirement savings and protect your assets. But there’s more to consider than just choosing the right stocks or bonds. Any additional income you earn from investing can also affect the amount you pay in taxes.

To minimize this impact, you’ll have to develop a strategy that considers both cash from interest and sales (i.e., “investment gains”) and the relevant taxes. First things first, however. Let’s go over some basics.

What is a taxable account?

A taxable account is one in which typical IRS tax rules apply. Some examples of taxable accounts include:

• Checking accounts
• Savings accounts
• Money market accounts
• Brokerage accounts

For these types of accounts, you are expected to pay taxes on any interest, dividends, or capital gains that your investments generate, in the year in which you earn them.

What are capital gains?

Capital gains are profits earned from the sale of an asset such as a stock, a bond, or something tangible like a house. The taxes levied on capital gains vary, depending on how long you hold the asset prior to selling, with “short-term” capital gains applying to assets held for less than a year and “long-term” capital gains applying to assets held for a year or more.

For interest, nonqualified dividends, and short-term capital gains, you are typically charged your normal income tax rate. Long-term capital gains and some qualified dividends typically have a lower tax rate. The government does this to encourage long-term investment, so it's usually in your best interest to carefully choose your investments and hold on to them.

Here are some scenarios in which you might use a taxable account:

• Short-term savings account that you may add to, or take from, on a regular basis—such as an emergency fund, or if you’re saving for a car, etc.
• Saving for retirement if you’ve exceeded contribution limits for nontaxable retirement accounts.

What is a tax-deferred account?

A tax-deferred account is one in which taxation on any investment growth is deferred until money is taken out of the account. Some accounts allow contributions that are deductible in the current tax year. In that case, the entire withdrawal is subject to taxes. In some accounts, the contribution is made with after-tax money and only the growth portion of the withdrawal is subject to taxes. Some examples of tax-deferred accounts include:

• Individual retirement accounts  (traditional and Roth IRAs)
• Deferred annuities
• 401(k) plans

What does tax-deferred mean?

Tax-deferred status refers to investment earnings—such as interest, dividends, or capital gains—that accumulate tax free until the investor takes constructive receipt of the profits.¹ Accounts with tax-deferred status are also commonly referred to as being tax-advantaged.

Taxable vs. tax-advantaged

While the returns on your investments are important, what’s perhaps more relevant is how much you get to keep after taxes. Small amounts can add up over time, so choosing the right asset allocation to maximize your returns is a strategy in and of itself. Diversifying your investments across different tax treatments also helps to give you more flexibility when you start drawing from your savings in retirement since you don’t know what the tax rate will be in the future.

To give you some idea, here are some common investments associated with taxable or tax-advantaged accounts.²

Taxable brokerage accounts are typically taxed at a normal rate, but provide greater flexibility and liquidity^* (i.e., fewer restrictions), and are commonly used to invest in:

• Stocks
• Index funds
• Exchange-traded funds (ETFs)
• Mutual funds that pay qualified dividends
• Surplus retirement savings (if you’ve maxed out your tax-advantaged retirement savings accounts)

Tax-advantaged accounts typically have more restrictions, but provide greater tax advantages and are ideal for:

• 401(k) plans
• IRAs

However, if all your money is in your 401(k) or IRA and you do not hold investments in both types of accounts, you can simply focus on choosing the appropriate investments for your needs. Ideally, you’d want to work with a financial professional who can help you determine the right asset allocations according to your goals, risk tolerance, and time frame.

Tax-smart investing strategies

To ensure that you keep more of your hard-earned money, here are some tax-smart investing strategies to consider that won’t require a deep dive into the tax code:

1.     Utilize tax-advantaged accounts

Take advantage of tax-advantaged accounts like 401(k)s, IRAs, and HSAs. Contributions to these accounts can reduce your taxable income, allowing your investments to grow tax free or tax-deferred.

2.     Hold investments for the long term

Capital gains from investments held for over a year are typically taxed at a lower rate. Long-term investing can help you minimize the tax impact on your gains.

3.     Tax-efficient funds

Consider investing in tax-efficient funds, such as index funds or exchange-traded funds (ETFs). These investments often generate fewer capital gains distributions, reducing your tax liability.

4.     Tax-loss harvesting

Offset capital gains by selling investments that have declined in value. This strategy can help you reduce your overall tax liability.

5.     Diversify your holdings

Diversification can help you manage risk, but it can also be tax smart. By having a mix of investments, you can choose which assets to sell in a way that minimizes taxes.

6.     Stay informed

Tax laws change, and being aware of these changes can help you make informed investment decisions. Consult a tax professional for answers to any tax-related questions you may have.

7.     Consider some municipal bonds in your portfolio.

Interest income from municipal bonds is often tax free at the federal level and sometimes at the state level. These bonds can be a tax-efficient addition to your portfolio.**

8.     Charitable giving

Donating appreciated assets to charity can be a tax-efficient way to support your favorite causes. You may be able to deduct the fair market value of the assets and avoid capital gains taxes.

9.     Estate planning

Have a well-thought-out estate plan to minimize the tax impact on your heirs. Proper estate planning can help preserve your wealth for future generations.

10.  Consider permanent cash value life insurance

Having permanent cash value life insurance, such as a whole life policy, can provide several tax advantages that can help grow and protect what you have acquired.

11.  Consult a professional

When in doubt, seek the guidance of a tax professional or financial professional who can help tailor your investment strategy to your specific financial situation.

When investing, it’s important to keep an eye on the tax implications of your decisions. Utilizing both taxable and tax-advantaged accounts allows you to take advantage of the benefits of both. Employing tax-smart strategies that help you maximize your investment returns and keep more of your money in your pocket can sometimes be tricky, however. So don’t hesitate to reach out to one of our financial professionals who can help you make the right decisions for yourself and your family.

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The information in this article is for educational purposes only and is not intended to be an offer for any specific product. Neither New York Life nor its affiliates are in the business of offering tax advice. You should consult with your professional advisors to examine tax aspects of any topics presented.

Securities offered by properly licensed registered representatives of NYLIFE Securities LLC (Member FINRA/SIPC) A Licensed Insurance Agency and a New York Life Company

¹Julia Kagan, “Tax Deferred: Earnings with Taxes Delayed until Liquidation,” Investopedia, November 3, 2023. https://www.investopedia.com/terms/t/taxdeferred.asp

²Coryanne Hicks, “Taxable Brokerage Accounts: The Most Versatile Investment Option,” Fortune, December 11, 2023. https://fortune.com/recommends/investing/taxable-brokerage-accounts-the-most-versatile-investment-option/

*The account value will be more or less than the principal.

**Certain interest, although exempt from federal income tax, may still be reportable to the IRS and, in certain circumstances, may be subject to the alternative minimum tax (AMT).