Understanding Tax-Efficient Investing with Guided Wealth Portfolios

What Is Tax-Efficient Investing, and Why Does It Matter?

Taxes are one of the most significant obstacles to reaching your investment goals. While you may be reaching your target goal in one of your accounts, the taxes taken out on your money could keep you from accomplishing what you had initially had in mind. That is why tax-efficient investing is a crucial strategy for helping you to get the best returns. Tax efficiency aims to lighten your tax burden as much as possible.

Before we discuss which investments would best suit your tax-efficient strategy, it is essential to understand the basics of taxes. If you have been investing for years, these terms may not be new to you, but they might help clarify things for those just starting.

• Ordinary income is any taxable money you receive from your salaries, tips, or bonuses.
  
• Taxable income is any of your money that is susceptible to being taxed after you make deductions.
• A deduction is any amount you can exclude from your taxable income.
• Tax liability is how many taxes you owe to the local, state, or federal government.
• Federal income tax is the tax on your taxable income from the government. Your taxable income is in a tax bracket that determines the percentage of your income that will be taxed.
• The cost basis is the original value of an asset.
• Capital gains occur when the value of a particular asset, such as a stock or bond, increases in worth. With this increase, investors can receive more than they originally invested when they sell because the price has grown. These can be short-term (less than a year) or long-term (over a year). There are taxes on your capital gains, which is something to remember when investing.

Now that you understand the different facets of taxes, you can better grasp the many ways they can affect your investment strategy. Since taxes affect most of your income, it is crucial to know how to prevent as much of your money from being taxed as possible so you can quickly reach your financial goals.

What Types of Investments Are Considered Tax-Efficient?

Some investments accumulate more taxes than others, which is something to consider when choosing what investments you want for your portfolio. You want to be sure you are selecting tax-efficient investments that will provide the best returns. Investment accounts are taxed in two different ways, so knowing which option works better for you is crucial.

Taxable Accounts vs. Tax-Advantaged Accounts

Taxable accounts are taxed based on the longevity of the investment, which could accumulate if the account has long-term capital gains. Whenever you choose to sell your investment, the capital gains you have received will be taxed. Taxable accounts are typically those you open with a brokerage firm where your money is invested across multiple assets like stocks, bonds, and exchange-traded funds (ETFs). Ideally, a taxable account works best for investments that you plan to have for over a year. Middle-aged adults should combine their use of taxable and tax-advantaged accounts to get the optimal results for their investments.

Tax-advantaged accounts might be more familiar to you. Retirement investments like 401(k)s and IRAs fall into this category, as well as 529 education savings plans. There are no taxes on capital gains you receive. The benefits of tax-advantaged accounts are that you can either wait and pay your taxes when you withdraw money (Traditional IRAs or 401(k)s), or you can invest with money that has already been taxed (Roth IRAs or 401(k)s). It’s important to know that these types of investments often come with more limitations. If you’re a young adult, tax-advantaged accounts might be a better investment choice for you because you have more time for your money to grow tax-free in a Roth IRA or 401(k).

While tax-advantaged accounts are typically more tax-efficient, it’s essential to know that taxable accounts can come in handy when trying to expand and diversify your investment strategy. Here are a few ways that taxable accounts are necessary for your portfolio.

1. Flexibility

Since tax-advantaged accounts have more limits on how many times you can withdraw your money and how much you can contribute, taxable accounts offer an opportunity to utilize your money when you want. It can be more of a hassle trying to access what you need without them.

2. Long-Term Capital Gain

Ordinary income tax rates can be up to 37%. That’s significantly higher than the rates on long-term capital gains, which range only from 15-20%.

3. Tax-Loss Harvesting

As we mentioned earlier, capital gains from your investments can be taxable. Tax-loss harvesting is when you can find ways to decrease your losses by canceling them out. For example, you could have a loss on one of your investments but a gain on another. You can use the amount you’ve gained from your investment towards the struggling one. This strategy helps you to offset your losses. Since you’ve paid yourself first, you won’t have to worry about owing a capital gains tax. This is how you’re able to “harvest” your tax losses.

Now that you understand more about how taxes affect investments, here are some investments that could work in your favor:

• Municipal bonds
• Exchange-traded funds (ETFs)
• Stocks
• Treasury bonds

All these investments are ideal for tax efficiency because they accumulate fewer capital gains. Municipal and treasury bonds are tax-exempt, so you won’t have to worry about losing your investing money.

What Are the Potential Downsides or Risks of Focusing on Tax Efficiency?

When you’re facing the challenge of dealing with taxes and your investments, it is important that you don’t get caught up in the weeds of being too focused on them and being afraid to invest in anything. It can be tempting to choose simple accounts and not take risks. Still, the reality is that every investment you select comes with some risk. It’s important to know that the National Credit Union Administration does not insure your investments.  Here are a few things to keep in mind when focusing on tax efficiency:

• Be cautious of changes in tax laws.
• Don’t just focus on the now. To better grasp your capital gains, it’s vital that you have a mixture of short-term and long-term goals.
• Some financial institutions charge for their services. Remember to account for these when seeking financial guidance.

Learn How to Navigate Tax Efficiency with Leaders Credit Union

Figuring out your taxes on top of your investments can be a tricky and frustrating task. Whether you want to start your investment plan over from scratch or you’re ready to jump in for the first time, our Investment Champions can be there for you to answer your questions about your guided wealth portfolio, tax-efficient strategy, and more. Learn more about investing by reading our free Investing 101 Guide.