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A Simple Guide to Building a Tax-Efficient Portfolio

The Motley Fool logo The Motley Fool 3/14/2019 Michael Aloi
a close up of text on a white background: The IRS is very grateful to those who don't minimize the taxes on their investments.© Getty Images The IRS is very grateful to those who don't minimize the taxes on their investments.

For many, tax season is an especially anxious time of year. As always, I procrastinated as long as possible, only recently sending my tax information to my accountant Sara. Now the waiting for her phone call begins. I cringe just thinking of it. It's like the call you get from a doctor. I can tell from the tone of her voice: If she's upbeat, that signifies I did enough withholding throughout the year and I'm good. But if she's slow and drawn out, that means I owe. My nerves get jittery thinking about it.

But if there is one kind of tax I don't want to pay, it's tax on my investments. There are all kinds of taxes on investments, including capital gains taxes when an asset is sold for a profit, and the tax paid on that measly interest in checking accounts. There's even a tax on the money you were owed on an investment after you die -- it's called income in respect of a decedent (IRD). Wherever there is money to be made, Uncle Sam is lurking there, waiting for his cut. Well, not this time, because I have a (perfectly legal) plan to minimize my tax bill. Here are three simple steps I use to pay less in taxes, and keep more of my money working for me. 

1. Use exchange-traded funds

Exchange-traded funds (ETFs) are a basket of stocks pooled together to mirror a certain investment sector like healthcare, or to track a benchmark like the S&P 500. Use of ETFs has exploded over the years, reaching over $4.4 trillion in global assets under management (AUM) in 2017, from $417 billion in 2005. That's a cumulative annual growth rate of 21%, according to an Ernst and Young survey.

The growing popularity of ETFs is largely due to the fact that they're more tax-friendly than actively traded mutual funds. Every year, mutual funds are required to pass their profits from trading on to their shareholders in the form of a capital gain distribution, which is considered taxable income by the Internal Revenue Service (IRS).

ETFs can avoid this for two reasons. For starters, ETFs typically trade less frequently than mutual funds, so there is usually less in the way of profits to distribute at the end of the year. The same can be said for index mutual funds, but with one caveat: An ETF's tax advantage is largely due to its structure. When ETFs redeem securities, they can typicallu do so in-kind, which means the ETF providers are allowed to swap out securities with a low cost basis, without having to realize as much in capital gains.

ETFs and mutual funds both have to distribute their gains, but because of the ETF's ability to swap out securities in-kind, ETFs can potentially realize less in capital gains distributions. If all this is too technical, just remember that all else being equal, if you have to choose between a mutual fund and an ETF, you'll have a better chance of paying less in capital gains taxes every year by investing in an ETF. 

2. Harvest those losses

No one likes losing money, but if you do make a losing bet, you should give those losses a purpose.

Tax-loss harvesting has to do with selling stocks or mutual funds with a loss to offset a realized gain somewhere else in the portfolio. (A "realized gain" means a sale that already happened in the year.) If you sold Stock A for a gain, you can use the loss from Stock B to negate the gain from Stock A, and pay less in tax.

While most experienced investors probably have heard of tax loss harvesting and already do it, many wait until the end of the year, which isn't always optimal. If the stock market takes an ugly turn during the course of the year, you have the option of selling and booking your losses. If you wait until the end of the year, the market may have recovered, and the good news is your investment is up, but the bad news is you can't book the loss if you need it to offset a gain.

Granted, selling a stock for a loss means you're exiting that position instead of waiting for it to recover and turn a profit for you, which could happen if the market rebounds. If that is a concern, then consider buying a similar stock or ETF to maintain that same exposure to the sector. For example, if you sell a losing tech stock to book the loss, you can buy a peer tech stock or a tech ETF as a temporary placeholder for this market sector. Hold this new investment for 30 days, then buy back the original stock or mutual fund on day 31, avoiding the wash-sale rule, and booking the loss. 

One problem with this approach is the temporary placeholder you buy to maintain exposure to the sector may generate a taxable gain of its own when sold after 30 days, which is not ideal, but the gain may be small because the time frame was short. You may not want to do this with all your stocks, but for the ones that aren't going anywhere, you can get some use out of them. Unused losses -- losses that weren't used to offset gains -- can be used to reduce taxable income up to $3,000 per year, or can be carried forward to the next year. 

3. Make the most of tax-deferred accounts

There's a reason traders love to buy and sell in IRAs and 401(k)s: There are no taxes owed on their trades. All gains and all earnings on investments are deferred in qualified retirement accounts. This huge benefit allows for more of your money to be reinvested and grow your portfolio.

To take full advantage of the tax-deferral of investment gains in retirement accounts, you'll want to use tax-inefficient assets inside these accounts. Tax-inefficient investments include high-yield bonds, actively traded mutual funds, real estate investment trusts, high-dividend stocks, and corporate bonds. All of these investments have one thing in common: They all generate a fair amount of income that -- while normally taxable in a regular investment account -- is instead reinvested in a retirement account. This strategy can certainly add up over time to boost your balance.

If you have investments outside of a tax-advantaged retirement account, consider using that account to buy tax-efficient investments, like ETFs, individual stocks, municipal bonds (if you're in a high tax bracket), and index funds or mutual funds with low turnover. All this can be summed up in two words: asset location, which means keeping your tax-efficient investments in taxable accounts and tax-inefficient investments in non-taxable accounts. 

In the investment world, there's only so much you can control. We can't push a button to move the stock market higher, but to some extent, we can control the taxes we pay on our investments. Buying tax-efficient ETFs, taking the time to pay attention to asset location, and harvesting losses throughout the year are simple strategies to keep the IRS out of your piggy bank.

Sara would be proud, I hope. I'm still waiting for the phone call.  

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