Tax-Efficient Investing 101

By Solon Vlasto, CFP®

Wealth Manager, Principal

February 13, 2023

Sound tax planning strategies should be a consideration when it comes to your investments. And even though interest rates have risen from the historically low levels of 2020 and 2021, tax-informed investment decisions could present the opportunity to improve your rate of return by a few percentage points. This is particularly the case if you are in a higher marginal income tax bracket.

Below are some strategies to consider as you aim to improve your after-tax rates of return on your investments over time.


Target long-term capital gains

Under today’s tax rules, there can be a significant difference in the tax implications of selling investments over a shorter versus longer period of time.

For short-term investments held for one year or less, you pay tax on any profits from the sale of an asset at your marginal income tax rate. In contrast, you can use a potentially much lower long-term capital gains rate to tax the profits on that same asset sale by holding the asset for at least one year.

Here is a simple example of the potential advantage of qualifying for long-term capital gains tax treatment: A married couple with a combined annual income of $465,000 would fall into approximately a 35% marginal income tax bracket under today’s tax rules. However, at their current level of income, they pay taxes on long-term capital gains at only a 15% tax rate. As a result, the couple can potentially earn an implied 20% additional return on their investment gains simply by holding an appreciated asset for at least one year in order to qualify for the long-term capital gains rate.


Take advantage of tax-deferred accounts

Contributions to your employer’s 401k remain a great tool for both a tax-deferred growth of your investments and a tax shield of your income.

Currently, you can contribute up to $22,500 per year (or $30,000 if over 50 years old) to a 401k plan, which will reduce your taxable income dollar-for-dollar. Any investment returns you earn in the account grow free of tax until withdrawn.

But you do not have to work for someone else to own and benefit from 401k income tax deductions and deferrals. In fact, if you are self-employed with no employees, an Individual 401k plan can offer you a valuable tax shield on your current income as an entrepreneur or consultant.

For example, you can make salary deferral contributions up to the same limits mentioned above on an employer-sponsored 401k plans (or up to 100% of your business income, whichever is less). In addition to these salary deferral contributions, you can also make profit-sharing contributions of up to 25% of compensation, assuming your business generates sufficient profits during the year. As a result, you could potentially shield up to $66,000 ($73,500 if over 50 years old) of your business profits in 2023 using an Individual 401k.[1] There is also no tax on your investment gains from assets held in an Individual 401k until you make withdrawals from the account later in life.

Finally, do not discount the value of tried-and-true Individual Retirement Accounts (IRAs). Currently, individuals can contribute up to $6,500 per year ($7,500 if over 50) into IRA accounts. You can contribute to a Traditional IRA and benefit from tax-deferred growth on investment gains until you make withdrawals (income limitations apply when determining the deductibility of the contribution). Roth IRAs offer tax-free (i.e., not deferred) withdrawals on gains. You can only contribute to a Roth IRA if your modified adjusted gross income is under $228,000 for married couples and $153,000 for single filers, which can make Roth IRAs a better contribution option for years when your income may be below these thresholds.[2]


Consider municipal bonds

People in the highest income tax brackets can still benefit from owning municipal bonds, even in today’s low interest rate environment.

For example, $1 million invested in income-producing assets yielding 1% annually would generate $10,000 of taxable investment income. If invested in tax-free municipal bonds, however, that $10,000 would not be subject to federal income tax (and sometimes is state tax free as well). If you are in the highest income tax bracket, you could potentially lose $3,700 of that $10,000 investment income to income taxes without the benefit of tax-free municipal bond income. For high earners especially, municipal bonds still potentially offer a much more favorable after-tax rate of return on investment.


Create a Donor-Advised Fund

Changes to the tax law have impacted some people’s ability to benefit fully from charitable contributions. Another option to consider is using a Donor-Advised Fund (DAF), where you can make larger charitable contributions, receive an immediate and up-front tax deduction, and then set up the fund to make regular grants to charities in the future. With a DAF, you can contribute a variety of appreciated assets to the fund, which allows you to avoid paying taxes on any accumulated gains on those assets. This can be a significant tax savings.


Remember, it’s not just about taxes (but avoiding them certainly helps)

At Modera Wealth Management, we believe individual investment decisions should not necessarily be made solely for tax reasons. However, a sound investment plan should factor in the implications of taxes where possible, which can optimize your rate of return over time. We can customize and develop investment strategies for you with an eye on minimizing taxes both now and in the future to help maximize your after-tax returns. Contact your Modera Wealth Manager to further discuss some of the options discussed in this article, or to explore other opportunities to improve your returns on investment through income tax management strategies.

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