Maximizing Returns by Minimizing Taxes: 10 Strategies for Tax-Smart Investing

Garrett Grigas CFA, CFP |

Investing is one of the most effective pathways to building wealth, but taxes can significantly erode investment returns. Over the last decade the average investor lost 20% of their growth to taxes!

This article explores strategies to minimize tax’s impact on your investments. From choosing your investment, to optimizing the right investment structure, and even what account type you use, each of these decisions impacts the taxes you will pay on your investments. Let’s dive into practical tips that make a meaningful difference in your investment strategy. 

1. Harvest Tax-Losses

Losses from an investment can offset gains from other investments on your tax return, but only if the investment with a loss is sold. By intentionally selling investments that are down, the losses are harvested and pass through to the tax return. This helps lower that year’s tax bill, and if there are losses left over, they can be carried forward for use in future years. 

2. Buy and Hold

The current tax system on investments favors investors who hold investments for longer periods. Gains earned by an investor are only taxed once the investment is sold, and short-term investors (those who sell within the first year of ownership) are subject to a higher tax rate. By focusing on long-term investments, taxes can be deferred until the investment is sold, with gains taxed at preferential rates.

3. Municipal Bonds

Municipal bonds pay tax free interest and are widely used by wealthy investors to manage taxable income. However, they aren’t the best choice for every investor, muni bonds often pay a lower rate of interest than normal bonds. Calculating the after-tax return for each type of bond at your tax bracket is essential to determining whether municipal bonds are the right choice for you.

4. Real Estate

Real estate offers two significant tax advantages:

  1. Investments in single-family real estate can be bought and sold without incurring taxable gains if the rules of a 1031 exchange are followed.
  2. Rental income can be partially or fully tax-free due to depreciation, which offsets passive rental income.

These strategies involve complex regulations, so consult your tax preparer to understand the details

5. ETFs over Mutual Funds

ETFs (Exchange-Traded Funds) have a distinct tax advantage over mutual funds. ETFs only trigger capital gains when sold, while mutual funds generate taxable capital gains in most years even when not sold. This difference makes ETFs tax-neutral, while mutual funds can lead to a yearly bill.

6. SMAs over ETFs

Separately Managed Accounts (SMAs) take tax efficiency a step further. SMAs can apply tax-loss harvesting (as mentioned earlier) and pass losses through to your tax return on an ongoing basis while the investment grows. While ETFs are tax-neutral, SMAs can have a positive tax effect.

7. Opportunity Zone Funds

Created by a 2018 tax bill, Opportunity Zone Funds provide two key benefits:

  1. Gains from the sale of other investments can be deferred if reinvested into an Opportunity Zone Fund when specific rules are followed.
  2. If held for over 10 years, gains from the sale of an Opportunity Zone Fund are tax-free.

Often holding real estate or a business development plant, Opportunity Zones can bring a serious tax boost to your portfolio

8. Retirement Accounts

There are few ways to avoid taxes on normal W2 income, but retirement accounts are the biggest opportunity to do that. They come in two main types.

 Traditional retirement accounts: Contributions are tax-deductible, and taxes are deferred until withdrawal in retirement.

  Roth retirement accounts: Contributions are not deductible, but all growth and qualified withdrawals are tax-free when regulations are followed.

9. 529s

If you're planning for future education expenses, a 529 college savings plan is your best tax choice. Contributions grow tax-free, and withdrawals for qualified education expenses are also tax-free. Additionally, many states offer tax deductions for contributions, enhancing the plan’s benefits.

 

10. HSAs

Health Savings Accounts (HSAs) offer a triple tax advantage:

  1. Contributions are tax-deductible.
  2. The account grows tax-free.
  3. Withdrawals for qualified medical expenses are tax-free.

Although contribution limits are low, maximizing this account can steadily build a tax-free fund for medical expenses.

 

General Guidelines

Consider Your Tax Bracket

Timing is crucial when realizing gains or losses. If you expect to be in a lower tax bracket in the future, delaying gains may be beneficial. Conversely, realizing gains sooner might help avoid higher future tax rates. Large gains are often best spread over multiple years to take advantage of lower tax brackets.

Stay Informed About Tax Laws

Tax laws frequently change, which can impact your investment strategy. Staying up to date on new legislation, credits, and deductions allows you to take advantage of new tax saving opportunities while avoiding being stuck in strategies that worked better with old tax laws. Regularly reviewing your investment strategy from a tax perspective is essential.

Consult a Tax Professional

Working with a tax advisor is one of the best ways to plan for and reduce taxes. A good tax advisor will also stay current on tax law changes and help apply them effectively to your investments.

 

Conclusion

Tax optimization is a critical component of any investment strategy. By leveraging these strategies, you can significantly reduce the tax drag on your returns and maximize your wealth-building potential. 

While understanding and applying these concepts is essential, the complexity of tax laws can be overwhelming. That’s why staying informed and consulting with a qualified tax professional is invaluable. Together, these strategies and professional guidance will help you navigate the tax landscape and keep more of your hard-earned returns.

Start taking steps today to make your investment portfolio more tax-efficient, it’s one of the smartest financial moves you can make!

 

Investors should consider the investment objectives, risks, charges and expenses associated with municipal fund securities before investing. This information is found in the issuer’s official statement and should be carefully read before investing.

Investors should also consider whether the investor’s or beneficiary’s home state offers any state tax or other benefits available only from that state’s 529 plan. Any stat-based benefit should be one of the many appropriately weighted factors in making an investment decision. The investor should consult their financial or tax advisor before investment in any state’s 529 plan.