Taxes might not seem like the biggest threat to your wealth right now, but they can have a substantial impact over time. Without a thoughtful strategy in place, the tax burden from capital gains, dividends, and interest income can compound and curb your ability to achieve your long-term financial goals. This effect—often referred to as tax drag—represents the reduction of your portfolio’s returns due to taxes.
Incorporating tax planning into your investing and wealth management strategy can help keep more of your money working for you. While every plan is unique, understanding the core tactics behind tax-efficient investing can give you a clearer view of what’s possible.
Here’s a closer look at the key strategies that can reduce tax drag and strengthen your overall financial plan.
Minimize ordinary income
Finding ways to minimize ordinary income can be an effective way to improve your tax efficiency. This type of income typically includes salaries, bonuses, tips, commissions, short-term capital gains, unqualified dividends, rent from a leased property you own, and royalties.
Ordinary income is usually subject to regular income tax rates, which can be as high as 37% at the federal level, based on 2024 rates. It may incur additional tax liabilities from state and local authorities, as well, which can further increase the tax burden, especially for those in high tax brackets.
There are a variety of strategies you can use to mitigate the impact of ordinary income on your taxes. This might include contributing to tax-deferred retirement plans, converting earned income into business income when appropriate, or being strategic about the timing of asset sales and withdrawals. Managing ordinary income is especially important in years when other taxable events (like a business sale or large bonus) could push you into a higher bracket.
Strategize where your assets are held
Asset location is the practice of aligning your investments with the most tax-efficient account types. Where you hold your assets can make a significant impact on how much they’re taxed and offer potential savings on your tax bill.
Income-generating assets like high-yield bonds, core bonds, real estate investment trusts (REITs), and utility stocks are typically taxed at ordinary income rates, which tend to be among the highest in the tax code. Investing in these types of assets through a tax-deferred or tax-exempt account can help protect distributions from annual taxes.
These types of accounts can include traditional IRAs and traditional 401(k)s, which allow qualified individuals to make non-taxable contributions and avoid paying taxes on income and capital gains until withdrawn, ideally at a time when your ordinary income is low.
On the other hand, certain assets have built-in tax efficiencies, even when located in taxable accounts. For example, the interest payments from municipal bonds are typically exempt from federal income taxes and may also be exempt from state taxes. Similarly, investments in index funds or exchange-traded funds (ETFs) tend to generate fewer capital gains, which can reduce your tax bill. Stocks held for the long term (more than a year) may also benefit from lower rates on capital gains taxes.
Understanding how returns on different assets are taxed, as well as which accounts offer the most favorable benefits, can help you make strategic decisions about where to hold them, ultimately improving your portfolio’s effective rate of return over time.
Use losses to your advantage
No portfolio is immune to market downturns and potential losses. But there are strategies to use those losses to help reduce your tax burden. Tax-loss harvesting allows investors to sell underperforming assets at a loss to offset realized capital gains elsewhere in the portfolio and reinvest the money into a different security. That loss can potentially offset up to $3,000 in ordinary taxable income. Losses that exceed $3,000 may be held to offset income in future tax years, which could help reduce tax drag down the road.
Using this strategy requires paying careful attention to IRS rules. For example, if you sell a security at a loss but then rebuy the same or a similar security within 30 calendar days, the IRS does not allow you to take a loss under the wash-sale rule. It can be helpful to work with a financial professional to ensure you comply with IRS rules and make the most of tax-loss harvesting opportunities within your portfolio.
Manage the timing of capital gains
Another opportunity to boost tax efficiency is by timing your capital gains in a favorable way. Capital gains are the profits you earn from selling an asset, like company stock or a second home. The length of time you hold an asset before selling it can significantly affect how much you owe in taxes. Short-term capital gains, which involve assets held for one year or less, are usually taxed at ordinary income rates. Long-term capital gains, however, are subject to a different tax rate, which can be significantly lower.
Timing the sales of your assets strategically can help you prioritize long-term capital gains rates over less favorable ordinary income rates. For example, you may hold off on selling a lucrative asset until after retirement, when your tax bracket may be substantially lower than when you’re regularly earning a salary. In some cases, spreading capital gains over multiple years or offsetting them with losses may also help reduce your tax burden.
Make your giving go further
Strategic charitable giving can reduce your tax burden while supporting causes that matter to you. You may be able to take an itemized deduction for donations you make to 501(c)(3) public charities, which can be a straightforward way to reduce your overall tax burden.
In addition to cash contributions, donating appreciated assets (such as stocks or mutual fund shares you’ve held for more than a year) can be an especially tax-efficient strategy. By giving these assets directly to a qualified charity, you can potentially avoid paying capital gains taxes on the appreciation while still receiving a deduction for the full fair market value of the asset.
Another option is to contribute to a donor-advised fund (DAF). These accounts allow you to make a charitable donation of cash, stocks, or non-publicly traded assets and receive an immediate tax deduction. That investment can then grow on a tax-free basis, potentially increasing the amount of money you can give to your favorite charities.
If you’re in or nearing retirement, you might also consider qualified charitable distributions (QCDs) from an IRA. These allow individuals at least 70 ½ years old to transfer up to $100,000 from an IRA to a qualified charity tax-free annually. Those QCDs can also count toward the annual required minimum distribution on your IRA if you’re at least 73 years old, helping you avoid a 25% excise tax.
Consider a Roth IRA conversion
A Roth conversion involves moving funds from a traditional IRA into a Roth IRA. You pay immediate taxes on the amount you converted, but you can let the amount grow and make qualified withdrawals in retirement tax-free. When timed correctly, such as early retirement or other times when you fall into a lower tax bracket, a Roth conversion could help you build a source of tax-free income for the future and improve the effective return on your Roth IRA.
This can also be useful for longer-term estate planning. Converting traditional IRA funds into a Roth IRA allows for future tax-free growth, which can be more advantageous than leaving tax-deferred assets to heirs, who may otherwise owe taxes on distributions. A Fulton private banker can help determine if the long-term benefits outweigh the upfront cost of making the Roth conversion.
When done strategically, tax optimization can improve your investment portfolio’s effective rate of returns and preserve more of your wealth. But even seasoned investors may find it difficult to reduce tax inefficiencies on their own. Changes to market conditions, tax laws, and even your lifestyle choices can alter your financial picture—and your potential tax bill—in ways that require ongoing adjustments. A Fulton private banker can design a strategy that aligns with your full financial picture and reduces your tax liabilities.
Learn how to protect more of your wealth—partner with Fulton Private Bank for tax-smart financial planning.
