Coordinating Tax and Investment Decisions
By Investment Analyst Elizabeth Molique
What is tax-efficient investing? How do taxes affect investment returns? Why coordination matters for wealthy families.
Albert Einstein received the 1921 Nobel Prize in Physics, the Copley Medal of the Royal Society of London, the 1935 Franklin Medal of the Franklin Institute, among other awards.[1] He purportedly said, “The hardest thing in the world to understand is the income tax,” implying income taxes were tougher for him to grasp than electromagnetism, quantum mechanics, Brownian motion, and relativity.[2]
“The hardest thing in the world to understand is the income tax.”
– Albert Einstein
What is tax-efficient investing?
At SJS, we work with you to understand the complex topic of taxes. Tax-efficient investing involves aiming to reduce and defer taxes through optimized investment management. Because taxes can significantly reduce a portfolio's long-term value, tax-efficient investing can be particularly helpful for taxable investors, especially for high earners or those with large estates.
How do taxes affect investment returns?
Focusing only on pre-tax returns can hinder portfolio growth by ignoring the intermediate impact of taxes; just as compounding boosts returns, it can also amplify fees and taxes. For taxable investors, what matters most is how much you keep after fees and taxes, not just how much you earn.
Charlie Munger, former Vice Chairman of Berkshire Hathaway, said, “The first rule of compounding is to never interrupt it unnecessarily.”[3] Interruptions include paying taxes as well as trying to time the market in the short term for buying and selling investments.
You can potentially reduce and defer taxes (interruptions) to increase after-tax expected gains by:
Investing In Tax-Advantaged Accounts
Investing in tax-advantaged accounts can help decrease tax-bills now, in the future, or throughout your life. Tax-deferred accounts - such as Traditional IRA, 401(k), 403(b), and 457 accounts - allow you to defer taxes by reducing income taxes owed today. However, money withdrawn in the future will be subject to income tax. Tax-exempt accounts - such as Roth IRA, Roth 401(k), Roth 403(b), Roth 457, and 529 accounts - allow you to contribute post-income tax money today and withdraw without any tax penalty, so long as you follow the necessary requirements. Finally, tax-free accounts that allow you to contribute and withdraw money that is not subject to income taxes can be particularly powerful, as long as the money is used for specific purposes, like a Health Savings Account (HSA) that is used for medical expenses.
Investing in Tax-Efficient Investments
Generally, if focusing on maximizing after-tax returns within a given asset class, we prefer broadly-diversified ETF and mutual fund investments that follow defined investment criteria with reasonable costs and lower turnover. Higher turnover usually indicates more trading costs and potentially higher distributions to investors, often resulting in more taxes paid by investors. Generally, the higher the income distributions, the more tax inefficient the investment is for a taxable investor. Each asset class / investment offers a different income distribution rate, and the various distributions may be subject to different tax rates. For example, emerging markets stocks typically have the highest percentage of non-qualified dividend income due to foreign-sourced income, which is subject to higher taxes even after foreign tax credits. The investment structure matters too: for example, ETFs often have structural tax advantages in comparison to mutual funds, such as in‑kind creation and redemption mechanisms that can help reduce taxable capital gain distributions.
Considering Asset Location
Asset location involves determining which investments to place in taxable, tax-deferred, and tax-exempt accounts. By holding tax-inefficient investments in tax-advantaged accounts, you may be able to achieve higher after-tax returns, while still having the same investments in your overall portfolio. Over time, the compounding of returns in tax-advantaged accounts can meaningfully affect your long-term wealth.
As an example of asset location, an investor may hold securities with high expected appreciation in a Roth IRA, and then place higher-yielding fixed income securities that generate significant taxable distributions in a Traditional IRA or other tax-advantaged account. Asset location is complex - tax rates, tax deductions, regulations, and investment characteristics change over time - but careful planning, implementation, and review can benefit the investor over the long term.
Realizing Income / Capital Gains in Different Times of Your Life
The timing of realizing, or selling, investments from a particular account can have a substantial impact on your portfolio’s after-tax return. For example, if someone has high current income and is approaching retirement, it may make sense to continue holding a legacy security (something you wouldn’t buy again today) in a taxable account until a lower income year in retirement, when their marginal tax rate may be lower. Realizing capital gains in a taxable account during retirement rather than higher-earning years may allow you to defer or even avoid significant taxes on the realized gains from appreciated securities, which could improve your after-tax outcome over time. Similarly, if someone needs money from a tax-advantaged account, it may make sense to withdraw from a Roth IRA in a higher-income year and then withdrawing from a Traditional IRA in a lower-income year. Tax-efficient timing of sales should be coordinated with your overall tax strategy and with advice from a qualified tax professional.
Using Tax Loss Harvesting
Within taxable accounts, if you realize a net loss on an investment position, you may be able to use the net losses to offset any current or future realized capital gains, subject to the wash-sale rule. Additionally, with remaining net realized losses, you may also be able to offset up to $3,000 in federal income for future years.[4]
Using Gifting & Charitable Donation Strategies
Gifting strategies can include giving money - cash and investments - directly to children or grandchildren (the donees). The 2026 annual gift tax exclusion allows an individual to give up to $19,000 per donee without need to file a gift tax return, or $38,000 per donee for married couples.[5] Some exceptions to this rule include gifting for specific purposes paid directly to the organization, like medical or tuition expenses. A family loan is another option. If you are charitably inclined, donating highly appreciated securities to a qualifying nonprofit organization or a Donor Advised Fund may help reduce taxable income in a given year and avoid realizing capital gains on the donated securities.[6]
Taxes are a given, but tax-efficient investing and coordination may help you keep more of your nest egg for yourself and the people and causes you care about. These strategies, alone and together, can provide meaningful results to your portfolio in a given year and over time.
At SJS, we coordinate with your tax professional to help implement your tax-efficient investment plan to achieve your financial goals.
Important Disclosure Information & Sources:
[1] “Awards & Honors”. Albert Einstein, alberteinstein.com.
[2] “Quote Origin: The Hardest Thing in the World to Understand Is Income Taxes”. Quotesearch, 07-Mar-2011, quoteinvestigator.com.
[3] Poor Charlie's Almanack: The Wit and Wisdom of Charles T. Munger, Expanded Third Edition. Charles T. Munger, 2005, Walsworth Publishing Company.
[4] Topic no. 409, Capital gains and losses. Internal Revenue Service, 25-Feb-2026, irs.gov.
[5] “Frequently asked questions on gift taxes:. Internal Revenue Service, 31-Dec-2025, irs.gov.
[6] “Publication 526 (2025), Charitable Contributions”. Internal Revenue Service, 17-Feb-2026, irs.gov.
Past performance does not guarantee future results. Diversification neither assures a profit nor guarantees against a loss in a declining market. There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results.
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