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Having a tax-efficient investment portfolio is a plus for many taxpayers. What makes this a desirable strategy when it comes to paying Uncle Sam and how can you make your investment portfolio even more tax efficient? There are plenty of ways to make more efficient investments and be financially savvy whether you’re investing on your own, with the help of new apps, products and services or with advice from a professional.
Tax Efficiency Defined
Tax efficiency is a measure of how much of the return on an investment is left over after you’ve paid your taxes. For example, an investment is less tax efficient the more it depends on income—as opposed to a change in its price—to generate a return. Essentially, you want to maximize the returns on your investments while paying the smallest possible dollar amount in taxes. To know where you stand, you’ll need to determine how your accounts stack up under the law. There are three types of accounts: taxable, tax-deferred and tax-exempt. Generally, you will want to make your tax-efficient investments in your taxable accounts, with non-tax efficient investments made in a tax-deferred or tax-exempt account.
Working Toward Tax Efficiency
It can be hard to save money from every paycheck, especially when money is tight, but if you invest wisely enough you can use passive income to supplement your budget. Investors can use tools like 7Twelve Portfolio to reduce risk and enhance performance, or online advisor resources such as FutureAdvisor and Betterment, which help you cut back on fees and optimize investment selections. These wealth management tools will help you boost your tax efficiency.
In addition, it’s wise to automate your savings by setting up weekly or monthly transfers to your IRA. Forbes advises keeping your costs low, diversify with index funds and the like, and maximizing your tax efficiency. The best way to go about this may be to actually take a step back from trying to aggressively out-perform the market and take a more passive approach to your portfolio so it rides the wave of the market.
While you certainly want to keep less tax-efficient investments in your tax-advantaged accounts, there are other factors to keep in mind. Regularly balance your portfolio by adding money to under-weighted asset classes. Keep in mind that active trading can often lead to decreased tax efficiency, and is better done in conjunction with your tax-advantaged accounts. When planning to leave large sums of money to your family members after your death, for example, it’s best to put stocks in taxable accounts because they are valued at the time of your death rather than when you first bought them (at which time they may have been worth much less). Place assets in a Roth IRA for a the potential for a better return on investment over time.
Tax-efficient investing is the best way to make sure you’re getting the most out of your investments. Keeping investments in accounts where they’ll be taxed most efficiently is one of the best ways to watch your money grow.