6 Tax-Efficient Investing Strategies for Tax-Aware Investors

Investment returns are subject to a variety of taxes, including ordinary tax rates, capital gains tax, state and local taxes, and others. The exact taxability of your investments can vary depending on their type and holding period. However, it is safe to assume that all your investments will be taxed in some way or the other. Paying tax is your duty as a citizen but considering the detrimental effect of taxes on your investment income, it becomes critical to implement tax-efficient investing strategies that can help you lower your tax output.

A financial advisor can help you implement suitable tax-efficient investing strategies while ensuring your portfolio aligns with your financial goals. This article will also discuss tax-efficient investment options and strategies that can help enhance your savings.

Below are 6 tax-efficient investing strategies that tax-aware investors can employ to lower their tax output:

1. Investing in tax-efficient investment accounts

Tax-advantaged accounts can help you save money and enhance your returns while simplifying tax. These accounts offer various tax benefits that can help you lower your tax liabilities while catering to distinct financial goals. There are several tax-sheltered accounts you can consider. Here's a closer look at some key options and their benefits:

• Retirement accounts: When saving for retirement, you can consider using tax-advantaged retirement accounts like a 401(k) or an Individual Retirement Account (IRA). Both types of accounts offer unique tax benefits, as highlighted below:

• 401(k): 401(k)s are workplace retirement accounts. There are two types of 401(k)s - traditional and Roth. Contributions to a traditional 401(k) are made with your pre-tax income, which helps you reduce your taxable income for the year of the contribution. However, you pay tax upon withdrawal during retirement. In 2024, the Internal Revenue Service (IRS) approved contribution limit for a 401(k) is $23,000, or $30,500, with catch-up contributions if you are aged 50 or older. Another great advantage of using a 401(k) is that employers may also offer matching contributions, which can further enhance your savings potential.
• IRA: IRAs can also be categorized into traditional and Roth. Just like a traditional 401(k), traditional IRA contributions are also tax-deductible, with taxes due on withdrawals during retirement. For 2024, the contribution limit for a traditional IRA is $7,000, or $8,000 if you are aged 50 or older. In contrast, Roth IRAs are funded with after-tax dollars, but qualified withdrawals, including earnings, are tax-free. The contribution limits for Roth IRAs are the same as for traditional IRAs, but eligibility for Roth IRA contributions depends on your income level.

It is important to note that the contribution limits for IRAs are relatively lower than the 401(k). Moreover, the IRA offers no employer match as it is not an employer-sponsored account.

• Health Savings Accounts (HSA): HSAs can be used to save for health expenses in retirement. These accounts offer triple tax advantages. Contributions to an HSA are tax-deductible, the account grows tax-free, and qualified withdrawals for medical expenses are also tax-free. For 2024, the contribution limit is $4,150 for individuals and $8,300 for families. People aged 55 or older can also make an additional annual catch-up contribution of $1,000.
• 529 education savings accounts: 529 plans help you save for the education expenses of your children or grandchildren. Contributions made toward a 529 plan are not federally tax-deductible, but withdrawals used for qualified educational expenses are exempt from federal and state taxes. Additionally, many states offer tax deductions on the contributions made to a 529 plan. In 2024, the contribution limits vary by state but are generally high and can help you save money.

2. Staying invested for the long term to benefit from long-term capital gains tax

The tax treatment of investment profits, known as capital gains, varies depending on how long you hold the asset before selling it. However, long-term investing is known to be more tax-friendly. Here’s a breakdown of how the holding period can affect your tax liability:

• Short-term capital gains: Short-term capital gains are gains from the sale of assets held for one year or less. They are taxed at the same rates as ordinary income tax, ranging from 10% to 37%, depending on your total taxable income for the year. In most cases, this results in a higher tax bill compared to long-term capital gains.

Short-term capital gains in 2024

• Long-term capital gains: If you hold an asset for more than one year before selling, your profit is considered a long-term capital gain and is subject to more favorable tax rates. In 2024, long-term capital gains are taxed at rates of 0%, 15%, or 20%, depending on your taxable income and filing status. For most taxpayers, these rates are significantly lower than short-term capital gains rates, which can result in better tax savings.

Long-term capital gains in 2024

As you can see, when it comes to taxes, it might be beneficial to hold investments for the long-term. The tax rates for long-term capital gains are much more favorable and can help you enhance your overall returns in the long run.

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3. Investing in municipal bonds

Municipal bonds can be another tax-efficient investment option. These bonds are issued by state and local governments to raise money for funding public projects. Municipal bonds are known for their tax advantages but can also provide other benefits, such as diversification and risk mitigation. 

Profits earned from a municipal bond investment are generally exempt from federal income tax. So, any interest you earn will not be subject to federal tax, irrespective of the holding period. In addition to federal tax benefits, municipal bond interest may also be exempt from state and local taxes. However, you must meet one critical condition to qualify for this benefit. If you reside in the state or locality where the bond was issued, you will not have to pay state or local taxes on the interest income. In other cases, the interest earned may be subject to state and local taxes.

You may also have to pay tax on municipal bonds if you purchase a municipal bond at a discount of less than 0.25% of its face value. In such a case, you may be subject to a de minimis tax on the discount amount. When this happens, the interest and profits earned from the discounted portion are taxed as ordinary income. Moreover, these will not be categorized as long-term capital gains, regardless of how long you hold the bond.

4. Using tax loss harvesting

Investing involves both profits and losses. While your profits are subject to taxation, you can use your losses to strategically offset these tax liabilities through tax loss harvesting. This approach allows you to lower your annual tax burden by utilizing your investment losses to reduce taxable gains. If you wish to benefit from tax loss harvesting, you need to sell an investment at a loss and use this loss to offset your gains earned from another investment in the same tax year. As per the prevailing rules, if your total annual capital losses are more than your total capital gains for the year, you can use up to $3,000 or $1,500 if you are married and filing separately, of those losses to offset other types of taxes on ordinary income. If you still have more losses beyond this limit, those can be carried forward to future tax years.

There are some considerations to keep in mind when using tax loss harvesting:

• Tax loss harvesting only applies to investments held in taxable accounts, such as brokerage accounts, as these accounts are subject to capital gains taxes. You cannot use this strategy for tax-advantaged accounts like 401(k)s, IRAs, and 529 plans that offer tax advantages because these accounts are not subject to capital gains taxes on profits or losses.
• You need to be mindful of the wash sale rule. According to this rule, you cannot buy a similar asset right after selling an investment at a loss. If you or your spouse repurchase a similar investment within 30 days before or after selling the concerned asset at a loss, the loss will not qualify for tax loss harvesting purposes.
• Lastly, in order to avail yourself of tax loss harvesting, you must complete all transactions and formalities before the end of the calendar year, i.e., December 31, to ensure the losses are applied to the current year's tax return.

Since tax loss harvesting can be relatively tricky to implement, you may consider hiring a financial advisor to carry out the process.

5. Investing in real estate

If you are wondering which is the best investment option for a person who wants to make a long-term, tax-free investment, the answer is real estate. Real estate offers numerous tax advantages, making it one of the best tax-saving investments.

Firstly, you can claim several deductions on your taxes arising from real estate. These deductions can include property taxes, mortgage interest, insurance premiums, and property management expenses such as utilities and lawn care. Additionally, expenses related to building repair and upkeep, advertising, travel for property management, legal and accounting fees, and business equipment like laptops and printers can all be deducted. However, to fully capitalize on these deductions, you must maintain accurate records of all these expenses to ensure they are accepted when you file your taxes.

Another significant tax benefit of investing in real estate is depreciation. Properties depreciate in value over time due to regular use and subsequent wear and tear. However, you can use this depreciation to deduct a portion of the property's cost from your taxable income. Residential real estate can be depreciated over 27.5 years, while commercial real estate has a depreciation period of 39 years. However, if you sell a property for which you have claimed depreciation, you will need to pay capital gains taxes on the sale. Thankfully, this tax can be deferred by using a 1031 exchange. A 1031 exchange can be used to defer taxes on the profit earned from the sale of a property by reinvesting the proceeds into another property. The only condition is that the property you choose for reinvestment must be equal to or greater in value than the property you sell. Real estate investments also offer an exemption from Federal Insurance Contributions Act (FICA) taxes, which are typically imposed on self-employed workers. Unlike self-employment income, rental income is not subject to FICA taxes.

Lastly, holding onto your property for the long term also allows you to benefit from lower long-term capital gains tax rates, which apply to profits from the sale of property held for more than one year.

6. Considering opportunity zone investments

Investing in opportunity zones can offer substantial tax incentives while allowing you to participate in economic development initiatives in the country. Created by the Tax Cuts and Jobs Act of 2017, opportunity zones are designated areas in the country that face economic challenges. These zones are selected by state governors and certified by the U.S. Treasury Department to encourage investment and stimulate growth in struggling communities. Currently, there are 8,764 communities across the District of Columbia, all 50 states, and five U.S. territories that have been certified as Qualified Opportunity Zones (QOZs).

Opportunity zones provide several key tax benefits if you invest your capital gains in these designated areas through a Qualified Opportunity Fund (QOF). If you have a capital gain from selling an investment, you can put that gain into a special fund called a QOF instead of paying taxes on it right away. This way, you do not have to pay taxes on the gain immediately. You can postpone the tax payment until either you withdraw from the QOF or until December 31, 2026, whichever comes first. This is called an “inclusion event.”

The extent of the tax benefits depends on how long you hold your investment in the QOF. Here’s how this works:

• Five-year holding period: If the investment is held in the QOF for at least five years, the basis of increases by 10% of the deferred gain.
• Seven-year holding period: The basis increases to 15% of the deferred gain for investments held for at least seven years.
• Ten-year holding period: If the investment is held for at least ten years, you become eligible to adjust the basis of the QOF investment to its fair market value at the time of sale or exchange. This means that any gains accrued after the investment in the QOF can be excluded from federal income tax.

Apart from capital gains, you can also use qualified 1231 gains to defer taxes using the QOF. Section 1231 gains refer to profits from the sale of certain types of property used in a business, including depreciable property like machinery and real property like buildings held for more than one year. However, these 1231 gains must be reported for federal income tax purposes by January 1, 2027.

To conclude

These six tax-efficient investing strategies can be beneficial in a variety of situations and are applicable to investors of all ages, risk appetites, and investment goals. Implementing these strategies can help you potentially reduce your tax liabilities while staying focused on your investment objectives, thereby addressing both goals simultaneously. However, given the complexity of tax procedures and the frequent changes in tax laws, it is advisable to consult with a financial advisor before adopting these strategies.

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