Tax-efficient investing: How to minimize investment taxes

Although taxes shouldn't necessarily drive your investment decisions, thoughtfully evaluating the asset classes you choose and the accounts you hold them in could help you lower your tax bill.
While tax rules and rates may change over time, the value of keeping taxes in mind when making saving and investing decisions does not. The reason? Taxes can reduce your investment returns from year to year, potentially jeopardizing your long-term goals.

Investing and taxes: What investors should know

Tax-efficient investing shouldn't supersede your existing investment strategy. Still, before you buy or sell an investment or contribute to a retirement account, it is important to consider the tax implications, especially if your current federal income tax rate is high. For starters, when you're settling on an appropriate mix of stocks, bonds and cash, it's helpful to understand how the IRS treats the income from those asset classes.

How investment income is taxed

The tax rate depends on the income's source. Keep in mind that future federal income tax law changes are always a possibility. Plus, state and local taxes may also apply.
Type of federal income tax Top tax rate Income source
Ordinary income 37%
  • Interest on bonds and cash
  • Short-term capital gains (profit on stocks, bonds and mutual funds held ≤ one year)
  • Withdrawals from traditional IRAs or 401(k) plans
Capital gains 20%
  • Long-term capital gains (profits on stocks, bonds and mutual funds held > one year)
  • Qualified dividends
Note: An additional 3.8% net investment income tax may also apply depending on your modified adjusted gross income.
Tip: It is rarely worth holding on to a stock you are ready to sell simply to avoid taxes — with one exception. Since gains on stocks held for a year or less are taxed as ordinary income, it may make sense to delay selling until they qualify for lower long-term capital gains rates.

Five strategies that can help maximize your tax efficiency

Tap + to learn more

1. Make the most of retirement accounts that can trim your taxes

To reduce federal income taxes — now or in the future — don't overlook the tax-advantaged retirement accounts you're eligible for, like IRAs and employer-sponsored 401(k) plans. View the current annual contribution limits here popup and check the table below for an overview of the potential federal income tax benefits. You can also use the retirement account selector tool to compare options.

How retirement accounts are taxed

When you're saving for retirement, you typically have the option to pay federal income taxes now or later.
Federal tax treatment
Type of account Current Future
Traditional IRA Contributions may be tax deductible; deduction amount may be limited if you (or in some cases your spouse) participate in an employer-sponsored retirement plan and your income exceeds certain thresholds. Tax-deferred growth potential; withdrawals are subject to ordinary income taxes.
Roth IRA Contributions are made on an after-tax basis; the amount you can contribute is limited based on your income. Tax-free growth potential; withdrawals will not be taxed if the requirements for qualified distributions are met (state taxes may apply).
Traditional 401(k) Employee contributions are made pre-tax, reducing your federal taxable income. Tax-deferred growth potential; withdrawals are subject to ordinary income taxes.
Roth 401(k) Employee contributions are made on an after-tax basis. Tax-free growth potential; withdrawals will not be taxed if the requirements for qualified distributions are met (state taxes may apply).

2. For more flexibility in retirement, diversify the types of account you own

To help potentially minimize your federal income taxes in retirement, consider using a combination of pre- and post-tax retirement accounts as well as taxable brokerage accounts. That way you can mix and match income sources to manage your tax bill.
Why diversifying your accounts now can pay off when you reach retirement:
  • No missed deductions. If you are eligible to take federal income tax deductions in retirement, you'll need taxable income to take advantage of them. Withdrawals from a traditional IRA or pre-tax 401(k) account are considered taxable income, so you could withdraw enough from those accounts to offset your deductions and then draw any additional funds needed from your Roth IRAs or Roth 401(k) accounts since qualified distributions are federally tax-free (and may be state tax-free).
  • More time for tax-deferred growth. If you have brokerage accounts to draw from, you can allow your traditional IRA and pre-tax 401(k) assets to continue to potentially grow tax-deferred until you are required to begin taking minimum distributions (typically at age 73). With a Roth IRA or Roth 401(k) account, the original account holder is never required to take withdrawals, so those investments can continue to grow on a tax-free basis indefinitely.
  • A different tax rate in retirement. Money contributed to a traditional IRA or 401(k) on a tax-deductible or pre-tax basis is taxed upon withdrawal at your future tax rate. In contrast, money contributed to a Roth IRA or Roth 401(k) account is taxed at your current rate, while qualified distributions are federally tax-free and may be exempt from state taxes. Since it's hard to know whether your future tax rate will be higher or lower than it is now, having both kinds of accounts covers you in both cases.

3. Don't overlook other tax-efficient investments

Retirement accounts aren't your only option for tax savings. These two types of investments offer tax benefits as well:
  • Tax-efficient funds. These could be tax-managed mutual funds, whose managers work deliberately and actively for tax efficiency, as well as index funds and exchange-traded funds (ETFs) that passively track a target index.
  • Municipal bonds and bond funds. Income earned from municipal bonds is generally income tax-free at the federal level and, in some cases, at the state and local levels. This applies when you hold a municipal bond or bond fund directly. Tax-exempt bond income is taxable as ordinary income when it's distributed from a pre-tax retirement account.
Check with your tax advisor to make sure you understand the tax features of these investments and to determine whether municipal bonds, which often have a lower yield than other bond options, may be an appropriate choice for your non-retirement portfolio.

4. Match your investments with the right account type

Taking full advantage of tax-efficient accounts and investments is just the first step. It's also important to hold stocks, bonds, mutual funds and ETFs in the most appropriate accounts from a tax perspective. Investing in this way can help ensure that you're realizing all potential tax benefits.

The best places for different types of investments

For greater tax efficiency, consider where to hold various investments. Just be sure that these decisions are consistent with your overall financial strategy.
Type of account What to hold Examples
Tax-favored (such as IRAs, 401(k)s) Investments that regularly generate taxable income
  • Taxable bonds
  • Stock funds with high turnover that distribute taxable gains and income
Taxable Investments that don't generate a significant amount of taxable income
  • Tax-managed mutual funds
  • Index funds and ETFs
  • Municipal bonds

5. Put your losses to work to offset gains

With a technique called tax-loss harvesting, you may be able to offset your investment gains with investment losses, which can help reduce your federal income tax liability. And if your capital losses exceed your capital gains, you can use them to offset up to $3,000 of federal taxable ordinary income each year as well, with additional losses carried forward to future tax years. For high-earning investors, the top 20% long-term capital gains tax rate plus a potential net investment income tax of 3.8% can make tax-loss harvesting even more valuable.
For more on this strategy, see "What is tax-loss harvesting and how does it work?"

Keep tax-efficient investing in perspective

Be sure to consult with your professional tax advisor before making decisions that will affect your tax liability. With each of the strategies described above, you should consider the impact of state and local taxes in addition to the impact of federal income taxes.
Whatever strategies you use, remember that tax efficiency isn't the only consideration for your investment decisions. You also need to think about how each investment can help you pursue your diversification, liquidity and overall investment goals — at a level of risk you are comfortable with. Tax efficiency then becomes another way to help you choose among your investment options.

More for you

Investing involves risk. There is always the potential of losing money when you invest in securities.

Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa.

Income from investing in municipal bonds is generally exempt from federal income tax and state taxes for residents of the issuing state. While the interest income is generally federal income tax exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the federal alternative minimum tax (AMT).

The investments discussed have varying degrees of risk. Some of the risks involved with equity securities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks.

Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
MAP8787754-09242027