Are You Set Up for Tax-Efficient Investing Before Filing Season?
When the market is experiencing volatility, it's common to focus on the gains and losses of your investments. However, the taxes you pay can also significantly affect your long-term returns.
The money that isn’t paid in taxes can stay invested, creating the potential for additional growth and compounding. Over time, those tax savings, if left to grow, may have an effect on the overall value of your portfolio.(1)
Finding the Right Location
A tax-efficient portfolio can begin with an asset mix tailored to your time horizon and risk tolerance.(1)
It may be beneficial to hold less tax-efficient assets in tax-deferred accounts, such as a traditional IRA or 401(k). These accounts allow you to withdraw funds in retirement, when you may be in a lower tax bracket.
Alternatively, tax-exempt accounts like Roth IRAs or Roth 401(k)s provide the advantage of tax-free withdrawals, both for contributions and earnings in retirement, assuming certain conditions are met.(1)
Consider Tax-Advantaged Accounts
Tax-advantaged accounts, such as 401(k)s and IRAs, may help your investments grow without being taxed on an annual basis.(2)
Retirement accounts provide different tax benefits, depending on the type:
Traditional retirement accounts may allow you to deduct your contributions, reducing your taxable income for the year.
Roth retirement accounts don’t offer an upfront tax deduction, but qualified withdrawals in retirement are generally tax-free. This offers flexibility to manage your taxes when you retire.(2)
Source: Edward Jones estimates. Assumes $750 in monthly pretax contributions from age 30 to age 65 and a 6% annual return. Traditional retirement account assumes tax-deductible contributions and are taxed at 25% at age 65. Taxable account assumes after-tax contributions, dividend and interest taxed annually at 25%, and capital gains taxed at 15% at age 65. This hypothetical example is for illustrative purposes only and does not reflect the performance of a specific investment. Values rounded to the nearest $5,000.
Avoiding Short-Term Gains Taxes
While strong investment performance is certainly positive, capital gains can create tax challenges, especially if you’re holding active mutual funds in taxable accounts. Gains on investments held for more than a year are classified as long-term gains and are taxed at a lower rate than ordinary income. However, if you sell an asset held for a year or less, the gain is considered short-term and taxed at your ordinary income tax rate.(2)
While you shouldn't hold investments solely to avoid taxes, it may be strategic to defer the sale of an asset until it qualifies for long-term capital gains tax rates.(2)
Tax-Loss Harvesting
Market volatility can present opportunities for reducing your tax liabilities through tax-loss harvesting, which includes selling investments that have decreased in value to offset taxable capital gains.
For example, net capital losses may offset taxable gains, and any remaining losses may be used to reduce up to $3,000 of taxable income ($1,500 for married individuals filing separately). Additionally, unused losses may be carried forward to offset gains in future years.(1)
In a volatile market, waiting until the end of the year or each quarter may cause you to miss tax-loss harvesting opportunities. However, tax-loss harvesting is complex, and investors must be aware of wash-sale rules, which may disallow the write-off.(2) We strongly encourage consulting with a tax advisor or CPA when making portfolio decisions intended to affect your tax status.
Article Sources:
(1) Fidelity Wealth Management. “5 ways to be a tax-smart investor.” Fidelity, January 2, 2025, https://www.fidelity.com/learning-center/wealth-management-insights/tax-smart-investing, Accessed February 13, 2025.
(2) Tierney, Katherine. “3 strategies for tax-smart investing.” Edward Jones, https://www.edwardjones.com/us-en/market-news-insights/guidance-perspective/tax-smart-investing-strategies, Accessed February 13, 2025.