When it comes to building long-term wealth, a solid, evidence-based investment strategy is one of the best ways to put the odds of long-term investment success on your side. Layering tax-efficiency on top of this solid foundation, can further improve your after-tax results. After all, it’s not what you earn, it’s what you keep.
At Core Wealth Management, a comprehensive, fee-only wealth management firm, we believe in pairing evidence-based investing with strategic tax planning to help our clients grow and preserve wealth more effectively. We do this by adopting a layered approach to tax aware investing—starting with the essentials and building up to more advanced, personalized and tax specific strategies.
Layer 1: The Essentials: Basic Investment Concepts Every Investor Should Use
Use Broadly Diversified, Low-Turnover Funds
Funds that trade less frequently tend to generate less taxable income. Think index funds and ETFs—they typically minimize capital gains distributions, making them a solid choice for tax-conscious investors. Plus, they align with evidence-based investing principles: broad diversification, low cost, and long-term focus.
Match Investments to Your Tax Bracket
Not all income is taxed equally, and investors should favor investments that make the most sense for their specific tax situation. For example, if you’re in a high tax bracket, municipal bonds (which offer federally tax-free interest) might make more sense than taxable bonds. By tailoring your investment choices to match your tax bracket, income sources and types of accounts you use, your overall tax burden can be reduced.
Layer 2: Strategic Tax Planning: Tailor Your Investment Strategy to Align with Your Financial Situation
Optimize How You Allocate Your Savings Across Retirement Accounts
Retirement accounts, like IRAs, Roth IRAs, and employer-sponsored plans like 401(k)s, receive special tax treatment under IRS rules. Investors can use these accounts to take advantage of differences in your tax rate at various points in life. For example:
- High-income years? Consider a traditional IRA or 401(k) which allows you to defer taxes when your rate is higher, with the goal of withdrawing the funds in retirement when you’re in a lower bracket.
- Low-income years? Roth contributions may be ideal when your current tax rate is low; you pay taxes upfront and enjoy tax-free withdrawals later.
This strategy can be especially powerful for younger investors, retirees, or anyone with fluctuating income.
Put the Right Assets in the Right Accounts (Asset Location)
Some investments are inherently more tax-efficient than others. Tax-inefficient assets, like bonds, are better held in tax-deferred accounts, like IRAs or low-cost variable annuities, where the income is not taxed until withdrawal. Investments that generate little income and are more growth-oriented in nature, like broad equity index funds, are well-suited for taxable accounts where favorable capital gains treatment can apply.
With this in mind, investors can implement a strategy known as asset location. By coordinating a unified investment approach across different types of accounts, investors can deliberately place investments in the most tax-efficient locations—boosting after-tax returns without altering the portfolio’s overall risk profile.
Turn Losses Into Tax Breaks
Through tax-loss harvesting, investments that have declined in value can be sold to offset other gains or to reduce taxable income. The proceeds from the sale can immediately be reinvested in a similar (but not identical) holding so that you stay invested and do not compromise your exposure to different parts of the market. Tax-loss harvesting can be an effective strategy to reduce your tax bill without compromising your investment plan.
Layer 3: Advanced Tax Optimization for High-Income or High-Complexity Investors
Utilize Separately Managed Accounts (SMAs) to Capitalize on Tax Loss Harvesting Opportunities
For larger portfolios, SMAs provide an opportunity for customized tax loss harvesting at the stock level. When your portfolio is comprised of mutual funds or ETFs, as an investor, you can only harvest losses at the fund level which can be hard to come by in a rising market. Because SMAs hold individual securities, an investor may have more opportunities to harvest losses at the stock level – after all, even when the overall market is up, that does not mean that the stock prices of all companies within the market are up. This creates more tax-saving opportunities without sacrificing growth potential.
High income investors, those with low-cost basis stock they want to diversify out of, or those with major taxable events like a business or home sale may find that incorporating SMAs into their investment strategy can be particularly useful and effective.
Use Charitable Gifting Techniques to Maximize Impact and Minimize Taxes
For those that are charitably inclined, there are tools and strategies available to make gifts to charity while also reducing your tax burden. Donating appreciated assets (instead of cash) to a qualified charity allows you, as the donor, to avoid capital gains taxes and to receive a tax deduction for the gift, and the charity, as the recipient, to fully benefit from the market value of the gift. A Donor-Advised Fund (DAF) can be used to “front-load” donations in high-income years and then allow you to distribute them to charities over time—maximizing the impact of both your gift and the tax benefit you receive.
Final Thoughts: It’s Not Just What You Earn—It’s What You Keep
Tax-efficient investing is an evolving process that should be aligned with your broad financial picture, including your income, your goals and even your location as state and local taxes can vary dramatically. It also is not a one-size fits all approach. Whether you’re just beginning to build a broadly diversified, low-turnover portfolio or you’re fine-tuning with strategies like tax loss harvesting, charitable giving and separately managed accounts (SMAs), integrating tax planning into your investment approach can lead to significantly better long-term outcomes.
At Core Wealth Management, we specialize in evidence-based, tax-aware wealth management that considers your full financial picture. A coordinated effort between your advisor and tax professional helps to ensure that you’re making decisions with a full understanding of your entire financial situation.