5 Steps to a More Tax-Efficient Portfolio

Jan 13, 2025

Discover ways to potentially increase your after-tax investment earnings.

Author
Daniel Hunt, Senior Investment Strategist

Key Takeaways

  • With lawmakers set to debate expiring U.S. tax code provisions in the months ahead, it’s a good time to review your portfolio’s tax efficiency.
  • Maximizing the benefit of tax-advantaged accounts like 401(k)s and 529 plans is an essential first step to creating a tax-efficient portfolio. However, it’s insufficient for higher net worth investors.
  • A holistic approach to tax efficiency can make a big difference in improving a portfolio’s potential after-tax returns, which may compound over time.
  • A Morgan Stanley study showed how a combination of tax-efficient strategies could generate nearly 73% more portfolio wealth over 20 years for a hypothetical high-net-worth investor.4

Important changes in U.S tax policy are on policymakers’ agenda for 2025.

 

Many of the provisions of the last major tax-code overhaul, the 2017 Tax Cuts and Jobs Act, are scheduled to sunset at the end of 2025. Among those set to expire are reductions in individual income tax rates and the scope of the alternative minimum tax (AMT), the $10,000 cap on state and local tax (SALT) deductions, and the increased estate and gift tax exemption.

 

The incoming GOP leadership in the White House and Congress favor extending the current tax cuts. However, without congressional action, the tax code would revert to its previous state, giving opposition lawmakers some leverage in negotiations. Additionally, changes contemplated by policymakers in both parties could vary widely in their impact on different taxpayers. As such, the next tax system may entail higher effective tax liabilities for some investors.

 

Whatever the outcome, it’s always a good time to take a closer look at how taxes may be reducing your investment earnings and consider strategies to help mitigate their impact.

Small Changes Can Make a Big Difference

There are a wide range of techniques you can use to improve your portfolio’s tax efficiency—and these can significantly enhance your ability to grow your wealth.

 

For example, simply deferring taxes on your investments by contributing after-tax funds to a 401(k), rather than a taxable account, can increase after-tax return by 1.5% per year for a sample equity portfolio over a 20 year horizon.1 To put that in perspective, that’s three times higher than the value a typical highly-ranked active equity manager added over their benchmark over the past 20 years.2

 

With that in mind, here are five steps you can take to help improve the tax efficiency of your portfolio. 

  1. 1
    Take Advantage of Tax-Advantaged Accounts

    Tax-advantaged accounts for retirement, education and health savings all offer significant tax benefits, but each comes with restrictions and limitations. Maximizing benefits often means weighing the tradeoffs of different account types.

     

    For example, traditional individual retirement accounts (IRAs) and 401(k) accounts are funded with fully deductible “pre-tax” dollars up to specified contribution limits.3 Investments in these accounts typically grow tax-deferred. Qualifying withdrawals are then taxed as ordinary income. By contrast, Roth accounts are funded with after-tax dollars, but assets in them can both potentially grow and be withdrawn tax-free.

     

    Choosing between these types often depends on your current and expected tax rate in retirement. Traditional accounts can be more efficient than Roth accounts if, like most people, your tax rate is lower in retirement. Other scenarios, however, tend to argue in favor of Roth accounts, which are not subject to required minimum distribution (RMD) rules that kick in at age 73 and can push investors into a higher tax bracket. 

  2. 2
    Make Tax-Smart Stock Investments

    Tax-advantaged accounts offer many benefits, but they also entail restrictions about how funds can be used and how much you can contribute. For investments held in a taxable account, there are other ways to help enhance tax efficiency—but getting the most out of these requires attention to the details, including choosing a strategy that is appropriate to the type of investment you’re seeking.

     

    Passively managed equity investments, for example, tend to produce fewer taxable gains because they generally buy and hold stocks over a long time period. Tax efficient as they may be, however, passively managed equities leave potential tax benefits on the table because their pooled nature generally precludes the practice of “tax-loss harvesting.” With tax-loss harvesting, stocks trading below the cost at which they were purchased are sold to realize those losses. That can help reduce your tax bill, as realized losses can typically be used to offset taxable realized gains in other investments.

     

    Direct indexing strategies are designed to deliver exposure similar to that of a passively-managed index, while benefitting from the potential value-add of tax-loss harvesting. In these strategies,  individual stocks from the benchmark equity index are purchased in a separately managed account, enabling the investment manager to employ tax-loss harvesting at the individual security level.

     

    Investors with large concentrated positions in individual stocks that have increased dramatically in value—a situation common to those who receive equity-based compensation—may benefit from exchange funds, which can help diversify the risks associated with such positions without triggering a large taxable event. How it works: Different investors pool their concentrated positions together into the shared fund, effectively swapping their individual concentrated positions for a proportional share in a diversified portfolio.

     

    Improving the tax efficiency of actively managed equity funds requires a different approach. These strategies tend to accumulate more taxable gains than passive strategies due to their more frequent trading. Holding these investments within certain types of insurance products, such as investment-only variable annuities or variable universal life insurance, may help shield you from realizing these taxable events over the course of your investment horizon. 

  3. 3
    Help Boost the Tax Efficiency of Your Bonds

    Bonds tend to play a larger role in your portfolio as you age, providing steady income and a potential cushion against market volatility. If you’re in a higher tax bracket, however, holding a large portion of your assets in bonds can create a significant tax burden, since bond income is typically taxed at higher rates than dividends from stocks. Fortunately, there are some techniques to help improve the tax efficiency of your bond holdings.

     

    Investing in municipal bonds can be an effective way to do so. Income from bonds issued by U.S. state and local governments are generally exempt from federal taxes and, if you live in the issuing locality, sometimes state and local taxes as well. While “muni bonds” usually have lower yields than corporate bonds, their tax savings may make their after-tax yields higher, depending on the specific investment and your tax bracket.

     

    Beyond muni bonds, indexed universal life insurance policies offer another tax-efficient option for those looking for stable, bond-like returns. These policies, which function much like variable universal life insurance, offer both a death benefit and a “cash value” account that pays policyholders an interest credit based on the performance of a market index such as the S&P 500. The account value can grow according to a formula that typically includes a minimum and maximum growth rate. 

  4. 4
    Consider Tax-Aware Alternative Strategies

    Despite their potential to help diversify your portfolio, many types of alternative investments are highly tax-inefficient. Hedge funds, for example, often use leverage and derivatives and trade at a high frequency. Accordingly, they often entail a high proportion of short-term gains, which are taxed at the top marginal rate the investor faces.

     

    Fortunately, there are certain types of alternatives designed for tax efficiency, as well as insurance structures that can help make other alternative investments more tax efficient.

     

    A prominent example of alternative strategies designed for tax efficiency is the emerging category of tax-aware “long-short” strategies. These supplement investment strategies often used by hedge funds with tax-loss harvesting to potentially improve their after-tax return.

     

    Other ways to potentially enhance tax efficiency include private placement variable annuities, another type of insurance product that can enable potential tax-deferred growth of tax-inefficient alternative investments, such as private debt, held within them. These types of annuities are similar to investment-only variable annuities, but typically have lower expenses and investment minimums starting around $500,000.

     

    Private placement life insurance can also help improve the tax profile of alternative investments held in the structure. These policies also offer a death benefit that’s generally exempt from income tax and, if held in a properly structured irrevocable trust, may also be exempt from federal estate taxes. That said, the cost associated with providing life insurance materially increases the cost of using these policies for their tax benefits relative to utilizing private placement variable annuities. When choosing between the two, investors should consider whether the life insurance features are aligned with their goals, as well as the typically-higher minimum investment size of these policies.

  5. 5
    Build Up and Draw Down Accounts Tax-Efficiently

    A holistic strategy for tax-efficiency also requires a thoughtful approach to how you place investments within the differing account types across your portfolio and how you withdraw assets from your accounts when the time comes.

     

    “Asset location” is a strategy that takes a broad view of your portfolio, seeking to match each investment you hold with the type of account most appropriate for it. While this can be complex in practice, the general idea is to place potentially high-growth, tax-inefficient assets within tax-deferred or tax-exempt accounts to help minimize any tax liability they may incur.

     

    While asset location is most appropriate for building wealth, other strategies can help you draw down your portfolio in a tax-smart way. “Intelligent liquidation,” for example, attempts to determine a more tax-efficient sequence to selling your investments to fund withdrawals, looking across different account types, securities and even specific tax lots. By sequencing withdrawals carefully, this may help reduce the realization of taxable gains within taxable accounts and allow assets in tax-advantaged accounts to potentially grow for longer, when compared to a pro-rata or haphazard approach.

     

    Finally, the technique known as “income smoothing” aims to level out your taxable income over extended periods of time. By avoiding income spikes that may push you into a higher tax bracket—an especially common occurrence in retirement when RMDs begin—you may be able to reduce your overall tax bill.

Work With Trusted Professionals

Tax efficiency can make a significant difference to an investor’s ultimate results. In one example, we estimated that a representative high-net-worth investor could generate 1.65% in additional return per year over a 20-year time horizon by using a combination of strategies for tax efficiency. Compared to a tax-inefficient baseline strategy, that adds up to nearly 73% more gains.4

 

Investors should recognize that tax-efficient investing requires a tailored approach. Each strategy can vary dramatically in its benefits and drawbacks based on individual circumstances, as well as the degree to which their unique characteristics may complement each other in your portfolio.

 

Seeking expert advice and using advanced planning tools is often the best strategy to help you enhance your tax efficiency and the likelihood of achieving your ultimate financial goals.

 

Consult your Morgan Stanley Financial Advisor and a licensed tax professional about how you may be able to increase your portfolio’s tax efficiency. With Total Tax 365, your Morgan Stanley Financial Advisor can implement strategies to help you reduce the impact of taxes, all year round. 

 

To learn more about tax-efficient investing, ask your advisor for a copy of the Global Investment Committee special report, Preparing for the Next Tax Regime: Six Steps to a More Tax-Efficient Portfolio.  

It’s What You Keep That Counts

Connect with a Morgan Stanley Financial Advisor to explore tax-smart strategies that may help you keep more of what you earn.

Check the background of our firm and investment professionals on FINRA's BrokerCheck.