Smart investors know that it’s not just what you earn—it’s what you keep. Taxes can take a significant bite out of investment returns, making tax efficiency a crucial component of portfolio management. While many focus on stock selection and market timing, few pay enough attention to tax-advantaged strategies that can boost after-tax performance over the long haul.
The Power of Tax-Efficient Investing
The tax drag on an investment portfolio can be substantial. In attempt to quantify how much so, Russell estimates that investing without the implementation of tax management into one’s investment strategy can cost investors between 16 and 25 basis points over time horizons beyond 5 years.
That may not sound like much, but we are fond of a quote by the late Charlier Munger that says, “The first rule of compounding is to never interrupt it unnecessarily.”
To that end, we offer 10 Common Pitfalls to Avoid:
- Ignoring Asset Location
Investors frequently hold tax-inefficient assets (e.g., bonds, REITs, actively managed funds) in taxable accounts rather than tax-advantaged accounts like IRAs or 401(k)s. This can lead to unnecessary tax burdens from interest income and frequent capital gains distributions.
- Overlooking Tax-Loss Harvesting
Many investors fail to realize losses strategically. Selling underperforming stocks to offset capital gains or ordinary income can significantly reduce tax liability. However, be mindful of the wash-sale rule, which disallows claiming a loss if you repurchase the same security within 30 days.
- Frequent Trading & Short-Term Capital Gains
Short-term capital gains (on assets held less than a year) are taxed at ordinary income rates, which can be much higher than long-term capital gains rates. Investors who trade frequently, especially in taxable accounts, end up paying higher taxes than necessary.
- Failing to Consider Dividend Taxation
Not all dividends are taxed equally. Qualified dividends receive favorable tax treatment (0%, 15%, or 20%, depending on income), while ordinary dividends are taxed at higher ordinary income rates. Investing in high-dividend stocks in a taxable account without considering these implications can increase tax liabilities.
- Poor Withdrawal Sequencing in Retirement
Taking withdrawals in the wrong order—such as pulling from tax-deferred accounts first instead of taxable accounts—can increase overall tax liabilities. A strategic withdrawal plan, balancing taxable, tax-deferred, and Roth accounts, can help minimize taxes over a lifetime.
- Ignoring Required Minimum Distributions (RMDs)
Investors with tax-deferred accounts (e.g., 401(k)s, Traditional IRAs) must start taking RMDs at age 73 (per SECURE Act 2.0). Failing to take RMDs results in severe penalties (up to 25% of the required withdrawal amount).
- Mismanaging Inherited Accounts
Beneficiaries of inherited IRAs or 401(k)s may be required to withdraw funds within 10 years (for non-spousal heirs), leading to unexpected tax burdens. Misunderstanding these rules can result in unnecessary tax bills or penalties.
- Overlooking State Taxes
While federal tax considerations are crucial, many investors forget about state capital gains taxes, which vary significantly. Some states, like California, tax capital gains at ordinary income rates, increasing overall tax liability.
- Not Utilizing Tax-Advantaged Savings for Education & Healthcare
Investors often fail to take advantage of Health Savings Accounts (HSAs) and 529 plans, which provide tax-free growth when used for qualified medical or education expenses.
- Failing to Plan for Tax-Law Changes
Tax policies frequently change. For instance, the current lower long-term capital gains tax rates could be adjusted in the future, and estate tax exemptions may shift. Investors who don’t plan for potential legislative changes may face unexpected tax consequences.
Outlook and Considerations
With potential tax policy changes always looming, staying ahead of tax implications is more important than ever. Investors should review their portfolios regularly to ensure they’re not paying unnecessary taxes or penalties and consult financial professionals to tailor strategies to their specific needs. With tax-efficient investing, even small adjustments can lead to meaningful improvements in long-term wealth accumulation.
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For more than 47 years, we have collaborated with our clients in their investment decision making process as they pursue their long-term financial goals. We are committed to keeping your goals, concerns and attitude about investing at the heart of your plan. If you’re ready to experience our personalized investment approach and exceptional client service, contact Jason R. Clark, CFA at 949.424.1013 or jclark@kovitz.com.
Kovitz Investment Group Partners, LLC (“Kovitz”) is an investment adviser registered with the Securities and Exchange Commission. This report should only be considered as a tool in any investment decision and should not be used by itself to make investment decisions. Opinions expressed are only our current opinions or our opinions on the posting date. Any graphs, data, or information in this publication are considered reliably sourced, but no representation is made that it is accurate or complete and should not be relied upon as such. This information is subject to change without notice at any time, based on market and other conditions. Past performance is not indicative of future results, which may vary.
