Have you ever driven down the street with the parking brake on?
With all the new technology in cars these days, this is harder to do now, but when I learned to drive in my 1995 Eagle Talon, it was easy to forget that hand brake. Next thing you know, your foot is on the gas pedal, and the car is just grinding as you pull onto that on-ramp on I-29 and you aren’t getting anywhere.
For your portfolio, that grind you are hearing is inefficient investing.
It’s an age-old dilemma: You’re diligently saving, your portfolio is growing, and you feel like you’ve got this. Then, tax season rolls around and you’re grinding uphill again as Uncle Sam takes his cut from your b gains.
Like all those lights and alarms on your dashboard to alert you to every parking brake, this is where tax efficient investing takes center stage. It isn’t a nice-to-have niche financial approach; it is a fundamental principle for building and sustaining wealth.
Recently, I had a meeting with a client that illustrated the financial drag of an inefficient portfolio. This client had always focused their retirement portfolio on high-dividend-paying stocks, believing this was the most reliable path for income. While the strategy generated cash, it also generated a massive, unnecessary tax burden.
The client was making quarterly estimated tax payments of well over $1000 per quarter, hundreds of dollars a month, just to cover the taxes on those dividends. This drain was significantly restricting what they felt they could comfortably spend each month.
Using our tax software, we ran a side-by-side comparison. We found that by restructuring their portfolio into a more balanced mix of low-turnover Exchange-Traded Funds, even including taxable bonds for necessary income, the client could virtually eliminate those quarterly tax payments.
This wasn’t a tweak; it was a game-changer. It immediately increased their usable monthly cash flow, giving them more freedom to spend without compromising their long-term plan.
Many investors, particularly those approaching or in retirement, make the same mistake, thinking they need high-dividend-paying stocks for income. A more efficient strategy can provide the necessary cash flow while reducing the tax bill.
The power of tax efficiency lies in two key areas:
- Eliminating “Tax Drag”: Taxes reduce the amount of money you have available to reinvest. Over decades, this “tax drag” can cost you tens or even hundreds of thousands of dollars in lost compounded growth. By intelligently leveraging tax-advantaged accounts (like 401(k)s or IRAs) and choosing efficient investments (like low-turnover index funds) in taxable accounts, you can accelerate compounding.
- Increased Spendable Income: By reducing your tax burden, you are able to spend or save more. It moves money from Uncle Sam’s pocket to yours.
What Exactly is Tax Efficient Investing?
At its core, tax efficient investing means legally minimizing the impact of taxes on your returns. It’s not about evasion; it’s about smart planning that ensures more of your investment growth stays in your pocket, compounding for your future.
Investments can generate different types of taxable events:
- Income: Interest from bonds, cash, or non-qualified dividends.
- Realized Gains: Selling an asset for a profit.
- Capital Gains Distributions: Mutual funds and ETFs passing on gains realized within the fund to you.
A tax-efficient strategy is built on intentionally managing these events, often by using the right account type for the right asset type and minimizing unnecessary taxable distributions.
Don’t let the tax bill erode your investment returns. Tax efficient investing is not a minor adjustment; it is a powerful tool that, when implemented correctly, can impact your financial trajectory and help your investment portfolio work smarter for you and your future.
Do you want to learn more and discuss how tax efficient your portfolio is? Just reach out to set up time to talk. We are always in your corner.
-Austin
