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MONTHLY INSIGHTS – NOVEMBER 2023
Edelman Financial Engines
October 31, 2023


TAX-EFFICIENT INVESTMENT STRATEGIES

WAYS TO HELP YOU KEEP MORE OF YOUR HARD-EARNED MONEY.

If you think understanding taxes and how to minimize them is difficult, you’re
in great company. As Albert Einstein once said, “The hardest thing to understand
in the world is the income tax.”

It’s certainly not easy! There are around 4 million words in the tax code and
regulations – that works out to roughly 9,000 pages. Can you imagine going
through all those pages to try and figure out the most tax-efficient ways to
invest?

Fortunately, you can enlist the help of professionals to do that work so you
don’t have to. But before we get into some tax-efficient investment strategies,
let’s start with a brief overview of the current tax structure.


U.S. TAX SYSTEM

In the United States, we have a progressive tax system, which means the more
money you earn, the higher your tax rate will be. And according to a 2019
analysis from taxfoundation.org, Americans as a whole spent more money on taxes
than on food, clothing and housing combined

Each state has its own individual income tax rates and rules. On the federal
level, every type of income is taxed, and they fall into three categories:

1. ORDINARY INCOME

This is income such as wages, bonuses and royalties, and as the name implies,
this type of income is taxed at what is known as ordinary rates, which are based
upon which tax bracket you are in.

2. CAPITAL GAINS INCOME

This type of income comes from the sale of stocks, bonds, mutual funds, ETFs and
other types of investments. The tax rate you pay on this type of income is
determined by how long you hold the investment. Income from investments held for
more than one year is taxed based on long-term capital gains rates, and for
investments held less than a year, short-term capital gains rates apply.

3. DIVIDEND INCOME

This is the money given to shareholders of certain stocks, usually on a
quarterly or annual basis. The exact tax rate you pay on dividends will depend
on whether it’s qualified or unqualified. Dividends have to meet certain
criteria set by the IRS to be classified as qualified, such as the kind of
company paying the dividend and how long the shares have been held.

Why all the different rates? Why do some types of income seem to be favored over
others, like long-term over short-term, or capital gains over ordinary income?
One reason is that long-term investments stimulate economic growth, so the
government wants to encourage that type of behavior.

And this friction, this difference in tax rates, is one of the reasons that
financial advisors like to focus on the tax consequences of an investing
strategy. Because there are different rates for different investment incomes,
there’s plenty of flexibility in how you can be tax-efficient in your investment
strategies.


CONTRIBUTE TO THE MOST TAX-ADVANTAGED ACCOUNTS

These are any type of investment accounts that offer some sort of tax benefit.
This could be a tax-deferred retirement account, such as a traditional 401(k),
403(b), 457, or deductible IRAs where pretax contributions are made and able to
grow tax-free until you withdraw them.

Other tax-advantaged accounts include Roth IRAs, 529 college savings
accounts and health savings accounts in which you contribute after-tax funds
that are then allowed to grow tax-free. All of these can contribute to
tax-efficient investment strategies.


UNDERSTAND YOUR DIFFERENT INVESTMENTS AND ASSETS

Knowing the kinds of assets you own and the types of accounts they are held in
is an important part of tax-efficient investing.

There are a lot of different variables involved in calculating a fund’s tax
efficiency, but in general, investment funds can be ranked in order from least
efficient to most efficient.

For example, passive ETFs are generally more tax-efficient than other types of
funds. Also, certain asset classes tend to be more tax-efficient than others.

Understanding the respective benefits and drawbacks of the different asset
classes you’re invested in is an important factor in deciding which types of
accounts to hold them in. This is where the help of a financial advisor can be
invaluable.


MANAGE CAPITAL GAINS INCOME

Tax-loss harvesting is a strategy that can be used to maximize the tax benefits
of capital gains, as it lets you realize losses today to offset capital gains
taxes that may be due in the current tax year or in future years.

For example, a hypothetical investor might have an investment that was bought 10
months ago, and therefore is subject to short-term capital gains tax rates,
which would be their ordinary income tax rate bracket. Selling the investment
recognizes a capital gain of $32,000, which would mean $11,200 in taxes due –
35% of the gain.

But if they hold another investment, also held for less than a year, which they
sell for a capital loss of $35,000, the loss offsets the gain. Not only do they
save $11,200 in taxes, they also have an extra $3,000 that can be used to offset
other ordinary income.

It’s important to note that tax-loss harvesting doesn’t allow you to avoid
taxes, just to defer them, putting them off into the future so that your money
can keep working for you in the present.


USE SMART RETIREMENT WITHDRAWAL STRATEGIES

Strategic withdrawals are just as important to consider as the investments in
your strategy. It’s important to determine when to take money out of different
types of accounts and to make sure you do it in a tax-efficient order. This can
be difficult to ascertain if you hold different types of taxable and nontaxable
accounts.

The challenge is making sure you optimize when to withdraw money to reduce
taxes. But what order is the right order? There’s not one rule that works for
everyone, but as a starting point, you should consider making withdrawals from
taxable accounts first, like brokerage accounts, bank savings accounts and other
monies in non-tax-advantaged accounts. This is because you have to pay taxes on
any interest, dividends and realized capital gains. These accounts offer the
least ability to defer taxes, so draw them down first.

Then you would tap into tax-deferred accounts next, like a 401(k) or traditional
IRA, and after that, tax-exempt accounts, like Roth IRAs or HSAs. But there are
times when this type of account ordering isn’t the wisest path, and once again,
this is where a financial advisor can help.


GIVE TO CHARITY

Charitable giving isn’t just an altruistic act, it’s something that can help
mitigate the impact of taxes as part of a comprehensive wealth management
strategy.

For cash donations, you can take an annual income tax deduction of up to 60% of
your adjusted gross income or AGI. For noncash items, like stock or real estate,
the limit is typically 30% of your AGI. If you do donate noncash assets to
charity, consider donating those with the highest appreciation because not only
will you be benefiting a charitable cause, you will also be maximizing the
asset’s value as a tax deduction.

To make your charitable giving as tax-efficient as possible, you need to time it
right, which can be done by using more complex giving strategies involving a
donor-advised fund.


STAY TAX AWARE ALL YEAR ROUND

It may sound simple, but one of the best things you can do is to plan for and
manage the tax efficiency of your investments all year long.

That involves reviewing your investments and financial plan on a regular basis
during the year. Obviously, this can be an overwhelming task, which is why it
might make sense to talk to a financial advisor who can help you plan your
investment strategy for tax efficiency.

At Edelman Financial Engines, we can help you identify the tax-efficient
investment strategies that might work for you, so you can consult with your tax
professional to determine which investing strategies we can help you put into
practice. If you’d like to learn more, contact an Edelman Financial Engines
advisor at (855) 224-1379, weekdays from 9 a.m. to 9 p.m. ET. We’re here for
you.

MATERIAL DISCUSSED IS MEANT FOR GENERAL ILLUSTRATION AND/OR INFORMATIONAL
PURPOSES ONLY, AND IT IS NOT TO BE CONSTRUED AS TAX OR LEGAL ADVICE. ALTHOUGH
THE INFORMATION HAS BEEN GATHERED FROM SOURCES BELIEVED TO BE RELIABLE, WE DO
NOT GUARANTEE ITS ACCURACY OR COMPLETENESS.

NEITHER EDELMAN FINANCIAL ENGINES, A DIVISION OF FINANCIAL ENGINES ADVISORS
L.L.C., NOR ITS AFFILIATES OFFER TAX OR LEGAL ADVICE. INTERESTED PARTIES ARE
STRONGLY ENCOURAGED TO SEEK ADVICE FROM QUALIFIED TAX AND/OR LEGAL EXPERTS
REGARDING THE BEST OPTIONS FOR YOUR PARTICULAR CIRCUMSTANCES.

 

© 2023 EDELMAN FINANCIAL ENGINES, LLC. THIS PUBLICATION IS FOR INFORMATIONAL
PURPOSES ONLY AND DOES NOT CONSTITUTE INVESTMENT ADVICE OR AN OFFER TO BUY OR
SELL ANY SECURITY. FUTURE MARKET MOVEMENTS MAY DIFFER SIGNIFICANTLY FROM THE
EXPECTATIONS EXPRESSED HEREIN, AND PAST PERFORMANCE IS NO GUARANTEE OF FUTURE
RESULTS. EDELMAN FINANCIAL ENGINES ASSUMES NO LIABILITY IN CONNECTION WITH THE
USE OF THE INFORMATION AND MAKES NO WARRANTIES AS TO ACCURACY OR COMPLETENESS.
FUTURE RESULTS ARE NOT GUARANTEED BY ANY PARTY. FINANCIAL ENGINES® IS A
TRADEMARK OF EDELMAN FINANCIAL ENGINES, LLC. ADVISORY SERVICES ARE PROVIDED BY
FINANCIAL ENGINES ADVISORS L.L.C. (FEA), A FEDERALLY REGISTERED INVESTMENT
ADVISOR. CERTAIN SERVICES PROVIDED ON AN EDUCATIONAL AND GUIDANCE BASIS ONLY.
CALL (800) 601-5957 FOR A COPY OF OUR PRIVACY NOTICE.

INVESTING STRATEGIES, SUCH AS ASSET ALLOCATION, DIVERSIFICATION OR REBALANCING,
DO NOT ENSURE OR GUARANTEE BETTER PERFORMANCE AND CANNOT ELIMINATE THE RISK OF
INVESTMENT LOSSES. ALL INVESTMENTS HAVE INHERENT RISKS, INCLUDING LOSS OF
PRINCIPAL. THERE ARE NO GUARANTEES THAT A PORTFOLIO EMPLOYING THESE OR ANY OTHER
STRATEGY WILL OUTPERFORM A PORTFOLIO THAT DOES NOT ENGAGE IN SUCH STRATEGIES.
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.

AM3182022

 


What to read next
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6 tips for building a tax-efficient investment strategy.
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What you need to know about tax-advantaged savings accounts.
January 23, 2018
Taxes and investing: What you need to know.
January 23, 2018
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