Tax-Efficient Investing

Two investors earning the same pre-tax return can end up with very different results after tax. Tax-efficient investing focuses on the return that is actually kept.

Common approaches include making full use of tax-advantaged accounts such as retirement and tax-free savings accounts; holding investments for longer, where long-term gains are taxed more lightly; choosing investments that generate less taxable income each year, such as broad index funds with low turnover; placing less tax-efficient investments in sheltered accounts, known as asset location; and realizing losses to offset gains, known as tax-loss harvesting.

For example, an investor with both a retirement account and a taxable account might hold bond funds, which pay regular taxable interest, inside the retirement account, and broad share index funds in the taxable account.

Tax efficiency should support an investment plan, not drive it. Holding an unsuitable investment just to avoid tax, or never selling because of the tax bill, can cost more than the tax saved. Because rules vary widely between countries and change over time, local rules matter.