Simply put, you don't want to pay more income tax than you're legally responsible for — nobody does. One way to avoid overpaying is using a tax‐efficient investment strategy.
There are several strategies that can help you reduce the tax you owe, and most of them are easy to use. Your job is putting your finger on the ones that will work for you and making the most of them. Your tax advisor can help you choose a strategy that works for you.
Taking long‐term gains and losses
If you own individual stocks and ETFs, you can reduce the taxes you owe on your profits by waiting to sell until you've owned an investment for more than a year. Then the profit will be taxed at your longterm capital gains rate, which may be lower than the rate you pay on ordinary income or on short‐term gains. In addition, long‐term capital losses can be used to offset long‐term capital gains.
Making tax‐exempt investments
You can also reduce the tax you owe on interest income by investing in tax‐exempt municipal bond funds. The income from most of these funds is exempt from federal income tax. If you're invested in a state‐specific fund that invests in tax‐exempt bonds issued by the state where you live, you may not owe state income tax on the interest either.
Choosing tax‐efficient mutual funds
Some mutual funds follow a tax‐efficient strategy that can work in your favor. A fund's prospectus describes the techniques it uses to be tax efficient. One of the most common is having a lower than typical turnover rate. This means the fund makes fewer changes to its portfolio than the typical mutual fund, so it generates fewer short‐term capital gains to be passed on to investors. Index funds tend to be among the most tax efficient funds, since their portfolios change only when there's a change in the underlying index.
Using tax‐advantaged savings plans
Using retirement savings plans and education savings plans that let you defer taxes on your earnings and, in some cases, on your contributions, may provide faster compounding of earnings and almost always a lower tax bill. Roth IRAs, Roth accounts in employer‐sponsored plans, Coverdell Education Savings Accounts (ESAs), and 529 college savings accounts provide tax‐free withdrawals — provided you follow the rules. Again, your tax advisor can help.
Tax‐efficient investing can backfire is if you make investment decisions exclusively to reduce your tax. That's never a good idea.