Tax efficient investing involves managing your investments in a manner that reduces the amount of your gains and income you end up paying as income tax. The taxation of different investment products and investment channels varies, so buying an investment in one manner can result in lower taxes than if the same investment was purchased another way.
Maximize Your Tax Deferred Investment Accounts
An important strategy is to deposit as much money as you can in tax advantaged accounts including your 401k account and IRAs. These account types allow the investment choices in the accounts to grow tax deferred until you need the money in retirement. Even if you cannot deduct IRA contributions, the accounts can be used for tax deferred growth or if set up as Roth IRAs, tax free growth.
Put High Tax Rate Investments in the Right Accounts
Investments like high-yield bond funds or real estate investment trusts -- REITs -- pay a high level of dividends, which are fully taxable. These investments can be tax managed by buying them in tax advantaged accounts like an IRA or 401k plan. Try not to buy these high yield investments in your taxable brokerage account. Another strategy to limit taxable income is covered call writing. A brokerage IRA account can be authorized for limited covered call option trading, allowing the gains from these trades to be tax deferred; this strategy also reduces record keeping for tax purposes.
Low Tax Rate Investments
In your taxable investment account buy those investment that are taxed at rates lower than your regular income tax bracket. Qualified dividends from stocks of companies organized as a regular corporation are taxed at a maximum rate of 15 percent. If you hold stock shares for longer than one year, gains will be taxed as long term capital gains, again with a maximum tax rate of 15 percent. Tax free municipal bonds may produce a higher after tax yield than taxable government or corporate bonds.
Manage Your Losses
Losses from investments can be used to offset other investment gains, reducing the capital gains taxes to be paid. Tax rules require losses to used to offset the same type of gains first, short term losses for short term gains and long term losses against long term gains. Excess losses can be used against the other type of gain and then other income. Remember, long term gains are taxed a a lower tax rate, so losses are more efficiently used against short term gains or other income. The timing of when you sell a losing investment can have a significant effect on the amount of investment taxes you pay.