Creating a More Tax Efficient Portfolio

Here are some simple tips to create a more tax efficient portfolio:

Invest in Index Funds

Index funds generate lower short-term capital gains and higher long-term capital gains due to much less frequent buying and selling.  Short-term gains are taxed every year as ordinary income.  Long-term gains are taxed at lower capital gains rates, and most are only realized when you sell your shares.

The idea here is to place assets that produce higher income (e.g. bonds) in tax advantaged investments (IRA, 401k) that will allow you to not to have to pay taxes annually on the income.

Then putting assets that generally produce less income (e.g. stocks) in taxable accounts.  You will have lower taxes each year, and when you sell your shares you will pay the lower long-term capital gains rate on your profits.

What about Roth IRAs and Roth 401k Accounts?

Since any gains in these accounts are tax free when withdrawn, it does make sense to put assets that will have the highest long-term growth in these accounts as well (e.g. stocks) as an exception to the rule above.

Caveats

It will often not be possible to execute this perfectly with all of your income producing assets neatly tucked away in your Traditional IRA and your growth assets in your Roth IRA and taxable accounts.

Also please do not let the desire for tax efficiency overwhelm having the right asset allocation for your long-term needs.  Tax efficiency is really a tactic not a strategy.