Everyone likes to make money, but nobody likes to pay taxes , so the next question becomes: How can I achieve decent growth in my portfolio but minimize the portion of my gains paid in taxes? On the other hand, an over-concentration on tax avoidance can place undue limits on those same, much-desired gains.
So, what is the right balance between attention to tax efficiency and focus on long-term gains? How can investors achieve desirable portfolio growth and not put the tax “cart” before the investment “horse”? Here are some basic principles that can help investors benefit from long-term growth and still exercise a measure of control over their annual tax liability.
Consider the Impact of Long-Term vs. Short-Term Gains
Under today’s tax rules, there can be a significant difference in the tax implications of selling investments over a shorter versus longer time period. 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 2025, the top marginal rate is 37%). By contrast, most taxpayers 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 $450,000 would fall into a 32% marginal income tax bracket, under today’s tax rules. However, at their current level of income, they pay for long-term capital gains at only a 15% tax rate. As a result, the couple can potentially earn an implied 17% 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.
When managing non-qualified investment accounts, two strategies can help improve tax efficiency. One is tax-loss harvesting, which means selling investments that have declined in value to capture the loss for tax purposes, while reinvesting in a similar fund so your portfolio stays positioned for recovery. Another approach is using mutual funds or ETFs designed with tax-efficient strategies that aim to reduce taxable gains distributed to investors, possibly lowering your overall tax liability.
Leverage Tax Deferral
Contributions to your employer’s 401k remains a great tool for both tax-deferred growth of your investments and a tax shield of your income.
Currently, you can contribute up to $23,500 per year (or $31,000 if over 50 years old) to a traditional 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, the appropriately named Individual 401k plan—sometimes called a “solo 401(k)”—can also 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 $70,000 ($77,500 if over 50 years old) of your business profits in 2025 using an Individual 401k. 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 $7,000 per year ($8,000 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 $236,000 for married couples and $146,000 for single filers, which can make Roths a better contribution option for years when your income may be below these thresholds.
Don’t Forget about Tax-Free Income
People in the highest income tax brackets can still benefit from owning municipal bonds, even in today’s relatively low-interest rate environment. For example, $1 million invested in income-producing assets yielding 5% annually would generate $50,000 of taxable investment income. If invested in tax-free municipal bonds, however, that $50,000 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 $18,500 of that $50,000 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.
The Big Picture
Certainly, 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. At The Planning Center, we work with clients to customize and develop investment strategies with an eye on minimizing taxes both now and in the future to help maximize your after-tax returns. Contact your TPC advisor 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.
And to learn more about taxes and your investments, visit our website to read our article, “Taxes and Your Investments: Understanding the Basics.”
