Understanding Tax Liability in Investment Planning
To optimize your portfolio’s performance, it’s crucial to consider tax liability alongside investment gains.
What Is Tax Liability?
Tax liability is simply the amount you owe in taxes to the government—federal, state, and local. It may include income taxes, sales taxes, capital gains taxes, property taxes, estate taxes, etc. In my opinion, income taxes, capital gains taxes, and estate taxes are the most important categories for investment planning.
Why Minimizing Tax Liability Matters in Investment Strategies
The less money you have to send to the government, the more resources you have available for yourself and your family right now. However, paying extra taxes doesn’t only affect how much money you have in the short term. It also means less money could be in your portfolio to grow and earn returns over time. So, paying out a small amount of money today can significantly impact your portfolio value over the years.
For example, what would you have lost if you had taken an extra $1,000 out of your portfolio for taxes 10 years ago? According to the Nasdaq[1], if that $1,000 would have been invested in an S&P 500 index fund, it would have earned you about $3,000. Maybe that doesn’t sound like a lot, but if the amount was $10,000 or $20,000 and that extra amount went to taxes every year of that decade, the losses would mount up into a significant sum.
Key Tax-Efficient Investment Strategies for High Net-Worth Individuals
Fortunately, there are ways to invest your resources that can result in a lower tax liability.
Leveraging Tax-Advantaged Accounts
There are two types of tax-advantaged accounts in which you can invest:
- Tax-deferred accounts are funded with pre-tax income; you pay tax when you take the money out, at whatever your income tax rate is at that time.
- Tax-exempt accounts are funded with after-tax money; withdrawals are tax-free.
Tax-deferred accounts can give you an immediate tax break on your contributions (subject to certain limits), so the full amount can go to work for you today. Tax-deferred accounts can be even more beneficial if your tax rate is likely to be lower when it’s time to withdraw funds. You essentially save the difference between your current and future tax rate. The most common types of these accounts are traditional IRAs and 401(k) plans.
Tax-exempt accounts provide future tax benefits instead of immediate ones. You pay taxes on your contributions but not on withdrawals (with specific requirements). The primary benefit of a tax-exempt account is that investment returns can grow and be withdrawn entirely tax-free. The most common types are Roth IRAs and Roth 401(k)s.
If you’re in a lower tax bracket now but expect to be in a higher tax bracket later, a tax-exempt account could meet your goals, while if you’re in a higher tax bracket now, the immediate tax benefits of a tax-deferred account may be more beneficial. If you contribute enough to a tax-deferred account, it might even lower your tax bracket and your tax liability on all your income.
Harvesting Tax Losses Strategically
When you sell an asset for more than you originally paid, the profit you make is called a capital gain. And when you sell an asset for less than you paid, the money you lose is known as a capital loss. Tax loss harvesting is a strategy to lower your tax liability by offsetting capital gains with capital losses.
The tax rate for assets held less than a year is your normal income tax rate, while assets sold after more than a year are subject to capital gains rates. For the 2025 tax year, capital gains rates are 15% for individuals whose income is $48,351 to $533,400 and 20% for those above that income level.
If you have investments in your portfolio that are not performing well, you may sell them at a loss to offset some or all of the capital gains on your profitable investments. That could enable you to save money that can be profitably invested.
Investing in Municipal Bonds
Investing in municipal bonds can be a tax-advantaged strategy, especially for high-net-worth individuals. Municipal bonds are sometimes referred to as tax-exempt bonds because the interest earned on them is often (but not always) exempt from federal income taxes and sometimes from state and local taxes as well.
Although munis often have a lower interest rate than taxable bonds, their actual yield can be higher if you’re in a 32% tax bracket or higher. Before investing, however, make sure the bonds you are considering meet your tax goals.
Advanced Strategies to Minimize Tax Liability
Investment strategies like the ones outlined above can help minimize your tax liability, but some options involve other aspects of your financial planning.
Charitable Giving as a Tax Strategy
The federal government incentivizes charitable giving with certain tax advantages. Generally, you can deduct, contributions of money or property you make to an IRS-qualified organization for tax purposes. The Internal Revenue Service has strict requirements for organizations seeking qualification, and you should check whether an organization you are interested in supporting is qualified.
There are overall limits on charitable donation tax deductions. You can generally deduct charitable contributions up to 60% of your adjusted gross income, but sometimes, 20%, 30%, or 50% limits may apply.
Estate Planning for Tax Efficiency
An essential aspect of estate planning is structuring your gifts to minimize tax liabilities. A variety of legal strategies can be used. These include gifting assets during your lifetime to family and charities or setting up various trust structures designed for specific circumstances, including providing you with income. Your lawyer and financial advisor can help you determine which strategies are appropriate for you and your beneficiaries.
Importance of Professional Guidance in Tax-Efficient Investing
Tax laws are complex and subject to change. Understanding all the ramifications of the latest versions is critical to designing tax-efficient investment and financial plans. A financial advisor who studies the laws and is knowledgeable about your entire financial situation can help you maximize your tax savings, even as the laws and your personal situation evolve.
To be custom-matched with a fiduciary you can trust to support your goals with customized planning and put your interests above theirs, take advantage of our advisor matching program today.
[1] https://www.nasdaq.com/articles/how-much-youd-have-if-you-invested-1000-sp-500-10-years-ago#
Mike Valenti is a non-registered affiliate of Cetera Advisor Networks, LLC.
Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 1/2, may be subject to an additional 10% IRS tax penalty.
A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 1/2 or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes. For complete details, consult your tax advisor or attorney.
