Let’s talk about everyone’s favorite subject . . . taxes! Okay, okay . . . I know that the subject of taxes probably falls fairly low on almost everyone’s list of favorite subjects. BUT, if you’re pursuing FIRE, you’ve got to know your taxes!
Taxes can be some of the biggest fees you face when investing, so the smart investor needs to know how to build a portfolio that is as tax-efficient as possible. And, guess what? I’m here to help you build your tax efficient portfolios!
Tax efficiency is an important element to building wealth and Amon and I tried to develop the most tax efficient portfolios that we could during our FIRE journey. So I’m going to guide you through some basics of being tax-efficient to help you reduce, or even avoid, those pesky taxes biting into your investments.
First, let’s get the most important question out of the way. What the heck is tax efficient investing?!
The answer’s in the question . . . but to be more specific: Tax-efficient investing is investing that involves choosing the right investments for the right kind of accounts to minimize the taxes you have to pay on them. And by reducing these taxes, you can invest more money in the stock market and grow your wealth even more.
And, of course, investing in the stock market can be fairly broad - you’ve got individual stocks, ETF’s, REITs, bonds, mutual funds, and plenty more. So, on one hand, you want to think carefully about what you’re investing in. On the other hand, you should also be thinking about where you put your investments.
Let’s start with the “where” first: There are two major types of investment accounts: Tax-advantaged accounts and taxable accounts. Let’s take a look at both.
It’s all in the name. These are accounts that either give you tax-deferred benefits or tax-exempt benefits. These were some of the first accounts that Amon and I ever invested in, and in our opinion, they’re sorely overlooked.
There are some great benefits to tax-advantaged accounts that you miss out on when you move straight to taxable accounts. Let’s take a look! The benefits of tax advantaged accounts:
They can reduce your taxable income: When you’re able to deduct all of our contributions to a tax-advantaged account (like a 401(k), traditional IRA, HSA, etc.), you get an immediate tax benefit.
They allow your assets and investments to grow tax-deferred: When using a tax-advantaged account, you don’t have to pay taxes on the capital gains or dividends (i.e., the growth of your money) while it remains in your account.
Having different accounts lets you withdraw money in tax-efficient ways: Withdrawals from different tax-advantaged accounts will be taxed differently. Having diversification on how you withdraw money from these tax-advantaged accounts is beneficial, and in some cases could mean no taxes at all!
So, there are great benefits to investing in tax-advantaged accounts. And there are generally quite a few different tax-advantaged accounts available. They may not all be available to you, but you should definitely research which ones you might qualify for.
To give you a bit of a headstart on the research, here are a few tax-advantaged accounts you may want to look into:
And there are other types of tax-advantaged accounts available depending on your personal situation. But many of these account types are totally ignored by the average person!
If you know anything about my investing style, you know that I’m a firm believer that using some of these tax advantaged accounts can be a great strategy for wealth-building, and shouldn’t be left at the table. I really recommend that you do some further research on these different account types and find out which accounts you’re eligible for and whether they work for you!
But, don’t stop there! If you’re able to identify all of the tax-advantaged accounts that you’re eligible for . . . and if you’re able to max out all of those accounts, why not move onto your taxable accounts?
Taxable accounts have fewer restrictions and are the accounts Amon and I personally used to invest after fully maximizing our tax-advantaged accounts. But essentially, taxable accounts are just traditional brokerage accounts. When you put money into a taxable account, you’re (sadly!) not getting any awesome tax benefits.
This is, of course, because awesome tax benefits aren’t endless! Because of this, you’ll likely be investing in both tax-advantaged and taxable accounts along your FIRE journey.
So, the next question becomes: What types of investments should you put in your tax-advantaged accounts and what investments should you put in your taxable investment accounts?
This is a really important decision because tax-advantaged accounts let you grow your investments, without having to pay taxes on the capital gains, dividends or interest while that money remains in your tax-advantaged accounts. So if you have something that pays high dividends (like a REIT for example), you want to think carefully about which account to put it in.
Here’s a general rule that you can use when deciding on where to put your different investments: As a rule, you want to place less tax-efficient assets in a tax-advantaged account, and more tax-efficient assets in a taxable account.
Less Tax-Efficient Vs. More Tax-Efficient Assets
When I talk about less tax-efficient assets, I’m talking about assets that generate a lot of capital gains and that you plan on holding for a short period of time (less than one year), or assets that pay high dividends. In contrast, when I’m talking about more tax-efficient assets, I’m talking about those assets that tend to have lower yields and lower returns and that tend to grow slowly.
Let’s take REITs as an example. REITs are required to pay dividends. Sometimes those dividends can be quite high. Don’t get me wrong - I’m not complaining about high dividend yielding REITs! But, REITs are a great example to illustrate the “less tax-efficient” asset. With steady dividends, as a general rule of thumb, REITs are seen as less tax-efficient and should be placed in a tax-advantaged account. The same can be said for high-yielding bonds, and EFTS or index funds that produce high yield dividends payouts. These are great assets for tax-advantaged accounts.
On the other hand, assets like total stock-market index funds or ETFs, or short-term bond funds with low-interest rates would be better off in a taxable brokerage account.
All in all, figuring out where to put your more tax-efficient and less tax-efficient assets is a tricky process. I recommend you make a list of all your investments and put them in order of most to least tax-efficient - This should help you figure out which assets should go in which kind of account.
So, take some time . . . make your list of investments . . . and start charting them by tax efficiency levels! I completely understand that taxes are never a straightforward subject. But hopefully, this breakdown has given you a good understanding of how you can be as tax-efficient as possible (and even avoid some taxes altogether!). Being able to cut down on your taxes is a great way to generate wealth, and implementing these ideas is an effective way to do that.
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