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Retirement Weekly: Tax efficiency: Understanding the tools that help you keep more of what you’ve invested

Most of us invest because we want to achieve certain life goals—whether it’s a comfortable retirement, securing an education, or building a legacy for family or charity. Yet sometimes there can be only a fine line between reaching our goals and missing the mark.

Taxes can trim investment returns, an effect that compounds over time. So even small reductions in tax costs can have a big impact on overall wealth. That’s why when it comes to investing, taxes need to be a part of the discussion. However, Financial Advisors do not offer tax advice and it’s important to seek a tax professional for specific questions.

But financial advisers and other professional who help manage money can help you better understand some basic principles — like tax-loss (or gain) harvesting and intelligent withdrawal (strategic tax-efficient asset purchases and sales)—and to consider their potential impact on your portfolio.

Building wealth: The more pre-tax dollars, the merrier

Small reductions in taxes can have enormous consequences for wealth accumulation.  During your prime earning and saving years, there are two main approaches to tax efficiency to consider: investing in tax-exempt securities or tax-advantaged accounts and/or postponing your tax liabilities through tax-deferral strategies.

Here are some common investment vehicles you might consider in the wealth-building phase of your financial journey:

Municipal bonds: Interest on municipal bonds (or “munis”) issued by U.S. states and municipalities are generally exempt from federal income taxes—and, if you live in the state of the issuer, often from state and local taxes as well.

Roth IRAs: Roth IRAs generally grow tax-free, and returns are exempt from income tax when withdrawn if certain conditions are met. Owners don’t have to take required minimum distributions (RMDs) and can make contributions into retirement.

Tax-deferred accounts: Tax-deferred accounts, such as 401(k) and 403(b) plans and traditional IRAs, give money more time to grow without incurring tax, which is typically assessed only at withdrawal. Contributions to these accounts may also be tax deductible.  Note: For healthcare savings and 529 education accounts, if withdrawn funds are used for qualified expenses, those withdrawals are also not subject to tax.

Investment-only variable annuities: Just like other tax-deferred accounts, variable annuities are not subject to IRS contribution limits and still protect investments from taxes until you take a distribution. And, unlike traditional tax-deferred retirement accounts, some variable annuities are not subject to RMDs, which can have a big tax bite.

Tax deferral in a taxable account: It’s possible to defer taxes even for a taxable account by holding positions longer before sales (which are taxable events) and, when trimming positions, by selecting tax lots with higher-cost bases. Some “tax-managed” strategies also employ so-called “tax-loss harvesting,” where losing positions are sold to realize losses and be temporarily replaced with similar investments. Tax savings are reinvested, exploiting the significant difference between short-term and long-term capital gains tax rates.

Tax-efficient asset location: Financial advisers can also help you take advantage of differences in tax treatment by locating investment types across all your accounts and maximizing the benefit of their tax advantages—a strategy that works only when you have both taxable and tax-deferred or tax-exempt accounts and hold different categories of investments.

Universal life insurance: A universal life insurance (ULI) policy offers tax-deferred accumulation, income-tax-free death benefits, and tax-free loans and withdrawals. The excess of premium payments above the cost of insurance and other fees and expenses are credited to the cash value of the policy, where it is invested and can grow tax free.

Enjoying wealth: strategizing your withdrawals

Of course, there comes a time when you’ll want to liquidate and use the money you’ve accrued through your investments. Having a tax strategy around this distribution phase is crucial—especially when it comes to retirement, where the accounts you choose to tap first (and the investment strategy you used) can make all the difference.

A common practice is to withdraw from taxable accounts first until they run dry, and then from tax-deferred accounts, and finally from tax-exempt accounts. However, if you’ve carefully saved more than you really need in taxable accounts, this approach may result in uneven income and adverse tax consequences.

A more strategic approach in this case is to time your withdrawals from tax-deferred accounts when those withdrawals would be subject to a lower tax rate—usually early in retirement before RMDs begin. You could then top-up those distributions as needed by using principal withdrawals from a taxable account or life insurance policy—which can help mitigate future tax liability, when RMDs force much of that income to be taxed at higher rates.

Wealth: Talking taxes beyond tax season

You want your money to support your life goals, and after-tax returns are increasingly important when it comes to making the most of your investments. Becoming more tax efficient may not be the flashiest financial trend, but it can become the MVP in terms of helping you reach your financial goals. While there are a variety of tax management strategies, not all can be combined, and some may not be applicable to your financial situation. Don’t hesitate to dig into this topic with your tax and financial professionals, whether it’s tax season or simply a good day to step up your financial strategy.

Lisa Shalett is managing director and chief investment officer for wealth management at Morgan Stanley.

© 2022 Morgan Stanley Smith Barney LLC.  Member SIPC.

This material is provided for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or to participate in any trading strategy. It does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Information and data contained herein is from multiple sources considered to be reliable and Morgan Stanley Smith Barney LLC (“Morgan Stanley”) makes no representation as to the accuracy or completeness of the information or data from sources outside of Morgan Stanley.

Morgan Stanley Smith Barney LLC recommends that investors independently evaluate particular strategies and/or investments, and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a particular strategy and/or investment will depend upon an investor’s individual circumstances and objectives.

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