Tax-Efficient Investing: Why Is It Important?

Benjamin Franklin's old line about death and taxes rings as true today as it did more than 200 years ago. Taxes are such a normal part of life that people may overlook them until it's time to file their returns. Unfortunately, by that point it may be too late to implement an efficient investment strategy for minimizing their tax bill. 

Returns lost to taxes

When it comes to investing, it's not just how much you make that matters—it's how much you keep after taxes. 

The Schwab Center for Financial Research examined the long-term impact of taxes and other expenses on investment returns and concluded that while investment selection and asset allocation are still the most important factors affecting your returns, minimizing taxes and other costs isn't very far behind. When it comes to investing-related taxes, even small amounts can quickly add up to a lot over the years. That's why the moves you make to reduce the drag taxes have on your returns matters so much. 

The good news is you can exercise a good deal of control here. With a bit of tax planning, you can maximize the tax efficiency of your portfolio and help reduce the effect of taxes on your investments. 

How do I maximize tax efficiency?

Investment accounts can be divided into two main categories, taxable accounts (like a brokerage account) and tax-advantaged accounts (such as an IRA, 401(k), or Roth IRA). Generally, investments that tend to lose less of their returns to taxes are good candidates for taxable accounts. Investments that lose more of their returns to taxes may be better suited for tax-advantaged accounts. Here’s where you might consider placing your investments:

Where tax-smart investors typically place their investments

Ideal for:
Ideal for:
Individual stocks you plan to hold for more than one year Individual stocks you plan to hold one year or less
Tax-managed stock funds, index funds, exchange-traded funds (ETFs), low-turnover stock funds Actively managed funds that may generate significant short-term capital gains
Stocks or mutual funds that pay qualified dividends Taxable bond funds, zero-coupon bonds, inflation-protected bonds or high-yield bond funds
Municipal bonds, I bonds (savings bonds) Real estate investment trusts

*Such as Roth IRAs and tax-deferred accounts including traditional IRAs, 401(k)s and deferred annuities.


Diversifying by tax treatment

Holding your investments in the most tax-appropriate type of account can complement your savings plans by helping to reduce taxes as much as possible (or, in the case of a Roth, eliminate entirely the taxes on investment returns).1 Spreading your investments across accounts with different tax treatments can also give you more flexibility in managing your taxes when you start drawing from your savings in retirement. Call it "tax diversification."

Diversifying by tax treatment can be especially important if you're uncertain about the tax bracket you’ll end up in down the road. For example, instead of choosing between a traditional IRA or 401(k) and a Roth account, why not split your contributions between the two? To minimize your tax burden, you could focus on taking tax-free municipal bond income, qualified dividends, and long-term capital gains from your taxable accounts and tax-free income from your Roth accounts. That would free you up to take only enough money from your taxable IRAs to keep you from moving into the next highest tax bracket (or to satisfy required minimum distributions, if applicable).


You can also leave such shares to your heirs who will receive a step-up in cost basis after you’re gone (more on that below). Roth IRAs also make a great bequest, as distributions are free from income tax for your beneficiaries.


Other tax-related investment considerations


Periodically rebalancing your portfolio to maintain your target asset allocation. Rebalancing involves selling and buying assets that have either grown beyond or fallen below your original allocation. When you take profits from your winners and buy assets that have underperformed, it could cause an additional tax drag on returns in your taxable accounts. You may also incur either long- or short-term capital gains when you take profits from assets that have grown. 





Keep more of your money with tax-efficient investments 

If you want to keep more of your income, managing your investments with tax efficiency in mind is a must. What's more, tax efficient investing techniques are accessible to almost everyone—it just takes some planning to reap the benefits.

1If you take a distribution of Roth IRA earnings before you reach age 59½ or before the account is five years old, the earnings may be subject to taxes and penalties.

About the author

Hayden Adams

CPA, CFP®, Director of Tax and Financial Planning, Schwab Center for Financial Research