5 Tips for A More "Tax Efficient" Investment Strategy

Everyone loves seeing their investments in their brokerage account or retirement plan grow from month to month. However, many people don't understand the tax implications of successful investing. Without deliberate planning, tax consequences can substantially wither an otherwise healthy investment return.

Tax Ramifications of Dividends vs. Capital Gains

First, investors need to understand both dividends and capital gains, and the difference between them.

When you own a stock, you are entitled to a proportional share of the excess profits the company distributes to its shareholders, called a dividend. Companies are not required to declare a dividend and many do not issue any, but many investors seek out stocks with a history of issuing dividends because of the income stream they provide. Dividends are taxed every year and the taxation rate varies by the stock, how long you’ve held it, and your income, but they usually will be taxed at a lower rate than your ordinary income.

The other primary way to make money through investing is through capital gains, which is when you sell your asset for a higher price than you bought it for (The original price you paid for an asset is called your basis). You are taxed on your gain above your basis. So if you bought stock XYZ 5 years ago for $10 and today you sell it for $25, you owe tax on the $15 difference. It’s important to note that while you own the asset, you are never taxed on changes in its price, but only when you sell it. This creates several important ramifications. Unless it’s within a tax-advantaged account like an IRA (more on these later), whenever you sell a stock, mutual fund, or other security, you incur a taxable event and must pay capital gains taxes.


Let’s illustrate what this could mean for your investments. If you could choose between an index fund that would return 6% annually before taxes over 10 years or a stock trading strategy that returned 6% annually before taxes over 10 years, what should you choose?

Overwhelmingly, the better strategy is the index fund because you would take home much more money. Even if we assumed zero trading costs for each buy/sell of a stock, the capital gains taxes incurred at each sale would eat into your net returns. When you consider additionally the future loss of interest income from taxes you paid, you begin to see how a tax-efficient investment strategy provides a significant advantage to investors seeking to build and secure wealth.

Many investors and financial advisers do not take these effects into account when they invest, and their after-tax returns pay the price. Also, the U.S. tax code is over 70,000 pages long, so it’s not surprising that there are even more tax considerations to weigh when investing. 

What can you do to be more tax efficient with your investments?

  1. Invest in tax advantaged retirement accounts, such as an IRA or your company’s 401(k). Because of the tax-deferred nature of these accounts, you will never pay capital gains taxes on investments within an IRA or a 401(k), along with other advantages.
  2. In after-tax accounts, hold your investments for as long as possible but only as long as prudent. Selling during the first year of ownership subject the sale to the short-term capital gains rate, which is significantly higher. Also, the fewer times you trade investments before you actually withdraw the money means the IRS gets to take fewer bites out of your portfolio.
  3. Be wary of the tax consequences of dividend-paying stocks and mutual funds. These can cause unanticipated tax liabilities if not planned for.
  4. Consider a strategy that includes keeping tax-managed funds for your after tax-portfolio and more aggressive funds in your tax-advantaged portfolios.
  5. Talk to your financial adviser about donating to charity in-kind. Also ask them about how they tax-loss harvest. The best advisers engage in these tax-saving practices. And did you know that many fees paid to a financial adviser are tax deductible?

At Idaho Medical Association Financial Services (IMAfS), we specialize in tax strategy for our clients, including tax-efficient investing. Contact us today for a no-cost consultation to see how one of our advisors can help you.