Investing and taxes: Strategies for tax-efficient wealth growth

A quick introduction to investment taxes

When you hear people talking about investment taxes, what they really mean is the taxes you pay on money generated by your investments (not on the investments themselves). Since the value of investments can rise and fall, you will only be taxed when you take money out of the market in one of the following ways*:

1. By selling an investment for more than you paid (what’s called a capital gain)
2. By earning interest on an investment (such as a bond or bond fund)
3. By earning dividends on an investment (such as a stock or real estate investment trust)
   

Fortunately, you don’t have to pay investment taxes as soon as you get the money. You just have to pay them whenever you file your federal return.

*While this is true in most cases, there are a few special exceptions. Please consult a tax or accounting professional for more information.

Is all investment income taxed the same way?

While dividends1 and interest income are usually taxed at the same rate (as ordinary income), money received from the sale of an asset is taxed as either a long-term or short-term capital gain.

What are long-term and short-term capital gains?

Long-term capital gains apply when you sell an investment that you’ve owned for more than a year. Conversely, short-term gains apply whenever you sell an investment that you’ve owned for a year or less.

Why are long-term capital gains better for taxes?

In most cases, short-term capital gains and investment income are taxed as ordinary income, which is subject to rates as high as 37% (depending on your federal income tax bracket). In comparison, long-term capital gains are usually capped at 20%.

2025 long-term capital gains tax rates²

The importance of tax-efficient investing

Which would you rather do: make a lot of money in the market, or keep more of the money you make? With tax-efficient investing, you can do both. That’s because this strategy seeks to maximize your overall return by minimizing the negative effects of taxes.

How do tax-efficient investment strategies work?

Tax-efficient investing is a strategy that uses a variety of techniques to reduce or postpone taxes for as long as possible. That way, you will have more money to invest—and more time to watch it grow.

Ten strategies for tax-efficient investing

Now that you know the basics of tax-efficient investing, let’s take a quick look at a few of the tools and techniques you can use:

1.  Contribute to tax-advantaged accounts

Contributions to tax-advantaged accounts like 401(k)s, IRAs, and health savings accounts (HSAs) can be an effective way to reduce your taxable income and allow your investments to grow tax free or tax deferred.

2.  Hold investments for the long term

Since the tax rate for long-term investments (those held for more than a year) is capped at 20%, they can be much more tax efficient than short-term investments (which are subject to rates as high as 37%).

3.  Invest in tax-efficient funds

If you invest in a nonqualified fund (not tax advantaged), choose one that has lower turnover ratios (sells assets less often), since they usually generate fewer capital gains. Index funds, exchange-traded funds (ETFs), and tax-managed mutual funds are often good places to start.

4. Strategically allocate your investments

If you own bonds, real estate investment trusts, or other investments that generate a lot of income, it usually makes sense to put them in tax-efficient accounts like 401(k)s and IRAs. That way you can postpone taxes until retirement when you may be in a lower tax bracket. On the other hand, if your investments are more tax efficient, like index funds and municipal bonds, you are probably better off (or at least no worse off) housing them in a taxable account.

5.  Use losses to offset gains (tax-loss harvesting)

Since investment losses can be used to offset capital gains, you can reduce your overall tax liability by strategically selling investments that have declined in value.

6.  Capitalize on cash value life insurance  

Cash value life insurance policies, such as whole life, offer a host of tax advantages—including a death benefit that’s income tax free (in most cases) and tax-deferred cash value growth. Do you have a need for life insurance? This last feature of cash value life insurance can be especially helpful if you have maxed out your qualified plan contributions because it gives you another tax-favored opportunity to build wealth. To make the most of this feature, you may want to look into variable universal life policies because they give you the opportunity to invest your cash value and pursue market returns.

7.  Have a withdrawal strategy in retirement

Since taxes can have a significant impact on your retirement portfolio, you may want to plan your withdrawals so that you are accessing them in the most tax-efficient order. While there are a host of other factors to consider, many financial professionals recommend the following schedule:

First – Taxable resources (regular savings, nonqualified investments, etc.)

Second – Tax-deferred resources (401(k)s, traditional IRAs, annuities, etc.)

Third – Tax-free resources (Roth IRAs, cash value life insurance, etc.)

8.  Consider charitable giving

Donating appreciated assets can be a tax-efficient way to support your favorite causes. Not only do you get to help a worthy organization, but you may be able to deduct the fair market value of the assets and avoid capital gains taxes.

9.  Create an estate plan

While estate planning  may not make your assets more tax efficient now, it can help preserve your hard-earned assets and minimize the tax impact on your heirs.

10.  Consult a professional

Since tax laws and market conditions are always changing, we recommend consulting a tax expert, accountant, or financial professional before making any decisions. That way, you’ll be sure to have the latest information and can develop an investment strategy that meets your specific financial needs.

Types of tax-advantaged accounts

Earlier we mentioned that tax-advantaged accounts are tools that you can use to accumulate assets more efficiently. To understand how they work, however, it’s important to understand the difference between taxable, tax-deferred, and tax-exempt accounts.

What is a taxable account?

Taxable accounts are generally the least efficient because you get taxed on your money twice: once when you earn it (usually in the form of payroll taxes), and again when you use it to build wealth (either though saving or investing). There are no special tax benefits whatsoever. Examples of these types of accounts include mutual funds, brokerage accounts, money market accounts, and savings accounts—just to name a few.

What is a tax-advantaged account?

Tax-advantaged accounts were created to help you save money for important financial goals like retirement, healthcare, and a college education. Since these accounts get special tax treatment, they can keep you from being taxed twice on the same money. How they go about it, however, depends on the type of account you select:

• Tax-deferred accounts allow you to contribute money from your earnings before they are taxed (what’s known as pre-tax income). These contributions are allowed to grow over time, and no taxes will be due until the money is withdrawn. Common examples of tax-deferred accounts are 401(k)s, traditional IRAs, 529 college savings plans, and health savings accounts.
• Tax-exempt accounts like a Roth IRA or Roth 401(k) offer tax advantages as well, but in the opposite order. Contributions are made after taxes are taken out, but the principal and growth are yours to use, tax free, once you reach age 59½.

How do I know which type is right for me?

In general, tax-deferred accounts are usually best if you expect to be in a lower tax bracket when you need the funds (such as retirement). On the other hand, you may want to consider tax-exempt accounts if you are in a lower tax bracket now and are more concerned about the impact taxes will have on your future. Of course, there are a host of other factors to consider—which is why it makes good sense to review your situation with your accountant, tax advisor, or financial professional.

Strategies for tax-efficient investing FAQs

How do I know if I need to use tax-efficient investments

Tax-efficient investments can help anyone who is interested in building and protecting wealth. It doesn’t matter if you are a new or experienced investor, minimizing taxes can play a key role in helping you get the maximum return.

Are there any downsides to tax-deferred accounts?

Yes, in most cases, you will pay a hefty penalty if you need to access the money early. Plus, all withdrawals from tax-deferred accounts are taxed as ordinary income, which can be higher than the long-term capital gains tax rate.

Are there any downsides to tax-exempt accounts?

There are a few, including no immediate tax benefits as well as strict contribution limits.

How do I open a tax-advantaged brokerage account?

In most cases it’s pretty easy. All you have to do is contact the company(either in person, over the phone, or online), complete an application, and fund the account using a bank transfer or check. Just make sure you select a tax-advantaged account that addresses your needs—whether it’s saving for retirement, college, or healthcare costs.

When would I want to use a taxable account?

You could use these accounts if you are in a low tax bracket, saving for a short-term need, or if you’ve exceeded the contribution limits for tax-advantaged retirement accounts.

What does tax deferred mean?

If something is tax deferred, such as a deferred income annuity, it means taxes will be postponed until you use the money. Until then, any growth you receive will be completely tax free.

What is the net investment income tax (NIIT)?

This is a separate tax you may have to pay if you have investment income and your modified adjusted gross income (MAGI) exceeds $250,000 (for joint filers), $125,000 if you’re married and filing separately, and $200,000 for all others. If you exceed these thresholds, you’ll have to pay a 3.8% surtax on your federal return.³

RELATED CONTENT

The information in this article is for educational purposes only and is not intended to be an offer for any specific product. Neither New York Life nor its affiliates are in the business of offering tax advice. You should consult with your professional advisors to examine tax aspects of any topics presented.

Securities offered by properly licensed registered representatives of NYLIFE Securities LLC (Member FINRA/SIPC) A Licensed Insurance Agency and a New York Life Company

¹Dividends that are generated by qualified investments may be taxed at the lower capital gains tax rate. 

²“Capital Gains Tax: How It Works, Rates and Calculator,” Nerd Wallet, March 3, 2025. 

³“Topic No. 559, Net Investment Income Tax,”IRS, January 2, 2025.