Five strategies for tax-efficient investing

By Bruce Hemmings
August 21, 2013

One area of investing that is easy to overlook is the effect of taxes on a portfolio. Yet most investors can improve a portfolio’s bottom line by employing a few simple tax-efficient investment strategies.

With higher top tax rates now in effect, it may be time to ask yourself: Are you doing everything possible to improve your portfolio’s bottom line through tax-efficient investing? Here are five tried-and-true strategies to help lower your tax bill while improving your net return.

Take Advantage of Tax-Sheltered Accounts

To encourage Americans to save for retirement, Uncle Sam offers tax incentives in the form of IRAs, 401(k)s, 403(b)s and other qualified retirement savings plans. These accounts provide the opportunity to defer paying tax on contributions and earnings, or to avoid paying taxes altogether on earnings, depending on the type of vehicle you choose.

By contributing as much as possible to these accounts, you can realize significant savings over time. For instance, contributing $400 per month to a traditional IRA will save you nearly $22,000 in taxes over 20 years, assuming a 5% annual return and 25% tax rate.1 (Taxes, however, will be due on distributions at the time you make withdrawals.)

Bruce Hemmings

For 2013, you can contribute up to $5,500 to a traditional or Roth IRA. And if you’re over 50, you can contribute an extra $1,000. For employer-sponsored retirement savings vehicles such as 401(k) or 403(b) plans, you can contribute up to $17,500 in 2013 and an additional $5,500 if you’re over 50.

But keep in mind that most withdrawals prior to age 59½ from a qualified retirement plan or IRA may be subject to a 10% federal penalty in addition to any taxes owed on contributions and accumulated earnings.

Turn to Municipal Bonds for After-Tax Yield

In today’s low-rate environment, finding yield can be a challenge. Rates on high-quality corporate bonds have hovered at historical lows, and the yield on US Treasuries has not topped 4% since 2008. While municipal bonds, or “munis,” are no exception, they carry one significant advantage: Interest paid by muni bonds is generally exempt from federal and, in some cases, state and local taxes.

Consider this: A municipal bond yielding 4% translates to a tax-equivalent yield of 5.33%, assuming a 25% tax rate. In other words, you would need to earn 5.33% on a taxable bond to receive the same after-tax yield as a 4% municipal bond.

Remember, however, that any capital gains arising from the sale of municipal bonds are still taxable (at capital gains rates), and that income from some municipal bonds may be taxable under alternative minimum tax rules.

Avoid Short-Term Gains

Before you sell an investment, check to see when you purchased it. If it was less than one year ago, any profit will be considered a short-term gain. If it was more than one year ago, the profit will be considered a long-term gain. That’s important because long-term capital gains are taxed at significantly lower rates than short-term capital gains, especially if you’re in a high tax bracket.

• Short-term capital gains are taxed at ordinary income rates which can be as high as 39.6%.
• Long-term capital gains are taxed at a maximum rate of 20% in 2013.2

Considering those different rates, it can pay to look at the calendar before you sell a profitable investment. Selling just a day or two early could mean that you’ll incur significantly higher taxes.

Make the Most of Losses

As most taxpayers know, the IRS lets you use long-term capital losses to offset long-term gains. In any given year, you can minimize your capital gains tax by timing your losses to correspond with gains. What’s more, you can carry forward unused losses to future years, and use them to offset future gains, subject to certain limitations.

You can also offset up to $3,000 of unused capital losses per year against ordinary income. So before taking a long-term capital loss, consider the timing of gains as well as ordinary income.

Get a Professional’s Perspective

Keeping an eye on taxes is a prudent way to try to enhance your investment returns over time. However, tax laws are complex, subject to change and may have implications you haven’t considered.


1. Example assumes monthly pre-tax contributions of $400 over a 20-year period, a 5% annual rate of return, compounded monthly, and a marginal tax rate of 25%. Example is hypothetical. Your results will differ.

2. Does not take into consideration Medicare tax on certain unearned net investment income or state or local taxes, which will vary.

Bruce Hemmings is a Financial Advisor and Senior Vice President with the Global Wealth Management Division of Morgan Stanley at Centerra. He can be reached at or (970) 776-5501.

The information contained in this article is not a solicitation to purchase or sell investments. Any information presented is general in nature and not intended to provide individually tailored investment advice. The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. Investing involves risks and there is always the potential of losing money when you invest. The views expressed herein are those of the author and may not necessarily reflect the views of Morgan Stanley Wealth Management, Member SIPC, or its affiliates. Morgan Stanley Wealth Management LLC. Member SIPC.

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