4 tax-smart steps to help investors build wealth

Morgan Stanley Wealth Management

01/29/25

Summary: Navigating the complexities of tax laws and investment strategies can be daunting. However, even small tax adjustments can help enhance your finances over time. 

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Thanks to the power of compounding, even small improvements in an investment’s after-tax growth rate can make a difference in the amount of money you’re able to accumulate over time.

Drawing from data-led insights by Daniel Hunt, a Senior Investment Strategist at Morgan Stanley Wealth Management, we explore four practical steps that can help you position your investments for potential tax efficiency. These insights can help whether you're just starting out or looking to refine your investment approach. Solutions range from simple to complex, so make sure that you understand the consequences of each strategy before deciding to implement it, and discuss with a financial or tax advisor.

1. Make the most of tax-advantaged accounts

One fundamental step in tax-smart investing involves making the most of tax-advantaged accounts such as 401(k)s and Individual Retirement Accounts (IRAs).

These accounts can offer significant tax benefits that may help accelerate the potential growth of your investments. For instance:

  • Traditional 401(k)s and IRAs generally allow you to invest pre-tax dollars, which can potentially grow tax-deferred until withdrawals begin, typically in retirement. Qualified withdrawals are taxed as ordinary income.
  • Roth accounts, on the other hand, are funded with after-tax dollars and offer potential tax-free investment growth and withdrawals.

Choosing between these accounts often depends on your current tax bracket and expected financial situation in retirement.

  • If you anticipate being in a lower tax bracket after retiring, traditional accounts might be more beneficial.
  • Conversely, if you expect higher tax rates in the future, Roth accounts could be more advantageous.
  • Additionally, some employers offer options to convert after-tax contributions to a Roth 401(k), offering the potential to contribute additional funds, up to a higher limit than that allowed by the IRS on elective salary deferrals.

2. Invest in stocks tax-effiiently

Beyond retirement accounts, there are strategies to help enhance the tax efficiency of your stock investments. For those who have maxed out their tax-advantaged accounts or face eligibility restrictions, considering how your stocks are managed can lead to potential tax savings.

  • Direct indexing, for example, allows investors to own individual stocks in a way that seeks to replicate the performance of a market index. This strategy enables personalized tax-loss harvesting opportunities, which can potentially reduce your tax liability by offsetting taxable gains with losses.

3. Smart bond investment techniques

As you diversify your portfolio, incorporating bonds can be crucial, especially as a potential buffer against market volatility in later life stages. However, some bonds offer more tax-advantaged opportunities than others. For example:

  • Investing in municipal bonds can be a smart choice. These bonds are generally exempt from federal income tax and, in some cases, from state and local taxes, which may make them attractive for investors in higher tax brackets.
  • Another option is Indexed Universal Life (IUL) insurance, which can offer bond-like investment returns alongside insurance features such as a death benefit. Policyholders are paid an interest credit based on the performance of a market index, with minimum and maximum growth rates that limit potential upside and downside. Potential cash value growth is typically tax-deferred.

4. Employ comprehensive tax management across your portfolio

Seeking tax efficiency isn’t just about selecting the right investments for you; it’s also about how and where you hold them.

  • Asset “location” – not to be confused with asset allocation - is a strategy that involves deciding where to place each investment to help maximize after-tax return potential. For example, investments with high growth potential but low tax efficiency might go in tax-advantaged accounts, while investments with lower growth potential but higher tax efficiency could be held in taxable accounts.

Additional considerations

Tax-efficient investing is a dynamic and complex aspect of financial planning that requires careful consideration and strategic decision-making. By understanding and utilizing the various accounts, investment types, and strategies available, you may be able to enhance the potential after-tax returns of your portfolio.

For sophisticated investors, it’s advisable to consult with financial advisors or tax advisors who can provide personalized investment advice based on your specific financial situation and goals.

This article by Daniel Hunt, Senior Investment Strategist for Morgan Stanley Wealth Management’s Global Investment Office, was originally published on January 8, 2025 as ‘5 Tax-Smart Steps to Help Build Wealth’.

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