It’s Not What You Make, It’s What You Keep: Improving Your After-Tax Returns

One underrated aspect of personal finance is investing a tax-efficient manner. The role of taxes in investing is often overlooked, typically because everyone’s tax situation is so different, making it difficult to give advice that applies to everyone.

But by thinking about the tax implications of your investments, you can make a big improvement in your investment returns. Here are some ways to maximize the amount of money you keep from your investment gains:

Investing in tax-deferred accounts

The most common way to minimize taxes is to use the tax-deferred and tax-free investment accounts that the government offers. Take advantage of your 401(k), Roth IRA, HSA, and 529 accounts to minimize the amount of taxes you have to pay on your investment gains.

Minimizing trading

It’s absolutely critical to avoid short-term trading in your taxable accounts. Short-term trading is taxed as ordinary income, which for some physicians can be 40-50%. Long-term capital gains, on the other hand, is taxed at a lower rate (sometimes as little as 0% for some residents).

The cost of short-term trading is very high, approaching that of mutual fund or financial management fees.

If you are going to engage in short-term trading, keep your trading in tax-deferred accounts to minimize the detrimental tax treatment of short-term treading.

Even if you are a long-term investor, the cost of switching asset allocations between low-cost index funds can be expensive. That is because you have to pay long-term capital gains taxes on your profits. As a result, you miss out on some compound interest when you switch index funds in your taxable accounts.

In some cases, investors will hold a stock indefinitely because of the high tax burden of selling appreciated shares.

Put tax-inefficient asset classes in tax-deferred accounts

In general, tax-efficient assets should be placed in taxable accounts, while tax-inefficient asset classes should be placed in tax-deferred accounts.

The Bogleheads wiki has a nice graph of the continuum between tax-efficient and tax-inefficient asset classes; I’ve simplified and summarized it below:

(adapted from Bogleheads wiki)

In general, tax-efficient assets are funds that kick off little to no taxable dividends or capital gains. This includes cash, municipal bonds, and non-dividend paying stocks. Stock index funds and index ETFs, because of their low turnover, are also tax-efficient.

On the other hand, bond index funds, actively managed stock or bond funds, and REITs pay out dividends and/or capital gains that you have you pay taxes on. When appropriate, it’s best to put these in tax-deferred accounts.

The concept of asset location is controversial: Jim Dahle at the White Coat Investor argues that because equities have higher expected returns, they should be put into retirement accounts to maximize the amount of investment gains that you can defer taxes on.

Hold mutual funds with low turnover ratios

Every time a mutual fund trades, it potentially causes a taxable event that gets passed onto investors. The turnover ratio is a metric of the trading frequency within a mutual fund.

Not surprisingly, actively-managed mutual funds have a high turnover ratio. The average turnover ratio for an actively-managed U.S. stock fund is 130%. The turnover of Vanguard Total Stock Market Index Fund Admiral Shares, on the other hand, is only 4.1%.

This makes it more likely for actively-managed mutual funds to have short-term capital gains taxes, which is not good for an investor who owns the mutual fund in a taxable account. If you must hold an actively-managed mutual fund, keep them in tax-deferred accounts.

Place dividend-paying investments in tax-deferred accounts

Dividends are paid by the underlying stocks in the mutual fund. While most investors choose to immediately reinvest these dividends, that does not exempt you from paying the appropriate taxes on these dividends.

In an ideal world, you would place dividend-paying investments in a tax-deferred account and non-dividend-paying investments in a taxable account. Some have chosen to allocate a portion of their taxable portfolios to non-dividend paying stocks such as Berkshire Hathaway.

Choose wisely between ETFs and mutual funds

When buying index funds, you often have a choice between the mutual fund version of the index fund and its ETF version. With Vanguard, there is no difference in the tax treatment, because of the special structure of Vanguard ETFs and mutual funds. However, if you invest with Fidelity or Schwab, the mutual fund will distribute a small percentage each year in capital gains, while the ETF will not. Regardless of where you invest, ETFs and mutual funds will distribute dividends, which you will need to pay taxes on.

Because of these considerations, I hold ETFs in my taxable accounts, and index funds in my retirement accounts.

Conclusion: Don’t Miss the Forest From The Trees

Investing in a tax-efficient manner is an important way to boost your returns. The best ways to minimize taxes on your investments is to maximize your retirement and tax-deferred accounts and minimize trading within your taxable accounts.

But because the benefits of some of the more advanced techniques (like asset location and choosing between mutual funds and ETFs) are small, don’t let tax considerations cause you to stray from other key investment principles. For example:

• Don’t avoid bond funds in favor of a 100% allocation in stocks because bonds  are tax inefficient
• Don’t buy a whole bunch of Amazon and Google because they “have no dividends”

Take taxes into consideration when you invest, but don’t let it dominate your investment strategy.

What do you think? Do you use any of the above techniques to reduce taxes on your investment profits? Do you have any other methods to maximize your after-tax returns?