Strategies to Help Boost After-Tax Returns

Key Takeaways

Federal tax rates on certain types of investment income can reach up to 40.8% for investors in the top tax bracket.^1,2 That’s a considerable investment cost. Yet when evaluating investments, many investors focus only on the return on investment (ROI) before taxes, not realizing their tax bite until it’s time to pay the tax bill each year.

Being mindful of the true investment return after taxes can help you make savvy investment decisions. There are several ways to invest tax-efficiently—all with the goal of improving your after-tax returns.

Why It’s Worth It to Be Tax-Aware

You could potentially pay less in taxes—and still stick to your investment plan—by choosing investments with better tax treatment. That means more money can stay invested in your nest egg to compound over time.

Understanding the potential after-tax returns on each of your investments will give you a clearer picture of the return you get to keep after paying Uncle Sam. Someone in the highest tax bracket with a goal to retire in 20 years may be disappointed to realize that a 10% rate of return on investments translates to an after-tax return of only 5.9% for bond income and 7.62% for stocks.

Calculating After-Tax Returns

Let’s look at the after-tax returns for an investment held by hypothetical investors Terry and Pam. The couple has a combined income of $375,000 a year and have $750,000 invested in an equity mutual fund. The fund’s dividend yield was 1.8% and had 10% in capital gains distributions before the end of the year.

Terry and Pam are pleased until they see their income tax return for the year. The dividends and capital gains distributions on equity mutual funds in a taxable account are potentially taxed at an18.8% rate, so their tax bill for holding this investment is about $17,000. The couple wonders whether they are truly reaching their financial goals.

Terry and Pam also have a $250,000 bond mutual fund investment held in a taxable account yielding 1.5% in income. Investment income from bond funds is taxed at the ordinary income rates. After calculating their income taxes, they estimate that their $1,000,000 total portfolio may cost up to $18,000 in taxes this year.

The Difference of a Tax-Aware Portfolio

Clark and Maria , another hypothetical couple, earn a household income of $375,000 and also have a 75% equity/25% bond investment portfolio totaling $1,000,000, like Terry and Pam. However, Clark and Maria chose a tax-managed equity mutual fund product that has no capital gains distributions but yields 0.13% in dividends, and a tax-free municipal bond fund that yields tax-exempt interest income of 0.09%.

Note: Municipal bond investments generate income that’s free from federal taxes and, in some cases, state and local taxes. They can offer yield advantages for those in both moderate and higher tax brackets.

Although the two couples have a similar stock/bond investment mix, they have starkly different tax costs for the year. Terry and Pam may pay nearly $18,000 in taxes on their portfolio income. Clark and Maria’s tax bill on their portfolio may be about $200.

Once you understand the impact of taxes on your investments, you can explore various tax strategies to see if you can keep more of your returns.

Steps to Help Enhance After-Tax Returns

Several strategies may add tax efficiency to an investment portfolio if they fit within your investment plan goals.

1. Make Tax-Mindful Investment Choices.

2. Choose the Appropriate Investment Vehicles.

Choosing which type of account (such as taxable, tax-deferred or tax-free) you use to invest your assets is another way to contain taxes. Placing investments that may create higher levels of interest income or capital gains distributions in tax-deferred investment vehicles will defer the taxes, and ideally you may be in a lower tax bracket later.

For Terry and Pam, holding their equity mutual fund account in their IRAs or 401(k)s could allow them to defer taxes on the fund’s distributions and decrease their current tax bill by over $17,000.

You should generally seek to place actively managed mutual funds, which generate capital gain distributions, in tax-deferred accounts such as 401(k)s and IRAs, while ETFs often work well in taxable accounts because of their tax efficiency.

You also want to consider the holding period of your investment in taxable accounts to potentially qualify for the preferred capital gains treatment. Otherwise, realized gains held for one year or less will be taxed at the ordinary income rates.

Investment Taxation by Account Type

3. Tax-Loss Harvest to Offset Realized Gains.

You can manage your taxable gain through tax-loss harvesting, by selling investments at a loss to offset gains.

For example, if your stock is trading at a loss of $2,000, that loss can offset $2,000 worth of gains you recognized from selling another investment. This strategy can be complicated, so it’s good to discuss with a tax professional.

Volatile markets can create more opportunities for tax-loss harvesting. Good candidates for selling would be investments that no longer fit your strategy or that can be replaced with similar ones.

One thing to watch out for is the wash-sale rule, which prohibits deducting the loss from selling an investment and replacing it with the same asset or a “substantially identical” investment 30 days before or after the sale.³ Triggering a wash sale would disallow the loss from offsetting the gain until a later date. (See the Wash Sale details in our tax FAQs.)

Putting It All Together

Having an eye on after-tax returns matters because you get to keep more of your money invested—and have the opportunity for the power of compounding to kick in—for your financial goals.

Bringing tax strategies into your investing decisions is well worth it and can eliminate sticker shock when it comes time to pay Uncle Sam each year.