Tax efficiency is a measure of how much of your return stays with you and how much ends up going to the government. Keeping an eye on taxes can be an important part of maximizing your investment returns.
The first step in building a tax-efficient portfolio is to understand where the investments — whether in taxable, tax-deferred, or tax-free accounts — will be held. Taxable accounts include brokerage accounts, and income from these accounts may be subject to long- and short-term capital gains tax and other taxes.
Long-term capital gains tax is a tax treatment applied to investments that have been held for a year or more. Short-term capital gains tax is applied to investments that are held for less than a year and are pegged to an investor’s tax bracket.
Investors looking to minimize their taxes might want to hold on to investments for more than a year to be subject to the longer long-term capital gains rates.
Tax-deferred accounts, such as 401(k)s and traditional IRAs, allow investments to grow tax-free as long as they remain in the account. Investors fund these accounts with pre-tax dollars, and withdrawals made after age 59½ are subject to regular income tax.
Tax-free accounts, such as Roth 401(k)s and Roth IRAs, are funded with after-tax dollars, but investments inside the account then grow tax-free. When investors make qualified withdrawals from these accounts, they pay no additional taxes.
As a general rule of thumb, tax-efficient investments, such as regular stocks, may be held in a taxable account, while investors may want to hold inefficient investments, such as taxable bonds, in accounts that have preferential tax treatment.