Tax-Efficient Investing

Q: Sarah, a high-income client in the 37% tax bracket, has $500,000 to invest across her taxable brokerage account and her traditional IRA (which currently has $300,000). She wants exposure to both equities and fixed income. Her adviser has recommended allocating her equity exposure through a low-cost S&P 500 index fund with minimal turnover and her bond exposure through a high-yield corporate bond fund. From a tax-efficiency perspective, how should these assets be located across her accounts?

**A is correct.** Tax-efficient asset location places tax-inefficient assets in tax-advantaged accounts and tax-efficient assets in taxable accounts. The high-yield bond fund generates ordinary income taxed at Sarah's 37% rate, making it highly tax-inefficient and ideal for the IRA where income grows tax-deferred. The S&P 500 index fund is tax-efficient due to minimal turnover (primarily unrealized gains), qualified dividends (taxed at 15%), and long-term capital gains treatment when sold. Holding it in the taxable account also provides basis step-up at death, eliminating embedded capital gains for heirs. B is backwards and highly tax-inefficient: it places the tax-inefficient bonds in the taxable account (triggering 37% annual taxation on interest) while wasting the IRA's tax shelter on already-efficient equities. C (splitting equally) sacrifices tax efficiency by placing some bonds in taxable accounts where they face the highest tax rates. D ignores that the IRA has limited capacity ($300,000) and wastes tax-advantaged space on already-efficient equities while forcing inefficient bonds into taxable accounts.

Q: Which of the following investment types is generally considered the MOST tax-efficient for holding in a taxable brokerage account?

**C is correct.** A low-turnover S&P 500 index fund is the most tax-efficient option for taxable accounts because it generates minimal taxable events: (1) most gains remain unrealized until the investor chooses to sell, (2) dividends are typically qualified and taxed at preferential 15%-20% rates, (3) when sold after more than 12 months, gains receive long-term capital gains treatment, and (4) low turnover minimizes short-term capital gains distributions. The fund's broad diversification and passive management keep trading activity minimal. A (high-yield bond fund) generates ordinary interest income taxed at rates up to 37%, making it highly tax-inefficient. B (REIT) distributes most income as ordinary dividends (non-qualified) taxed up to 37%, though some portion may qualify for the 20% QBI deduction. D (actively managed fund with 120% turnover) generates substantial short-term capital gains distributions taxed at ordinary rates, making it tax-inefficient despite being equity-based.

Q: An investor comparing two similar equity mutual funds for a taxable account calculates the following for each fund over one year: Fund A (Tax-Inefficient): 8.00% pre-tax return, 2.5% annual turnover generating short-term gains, 0.60% expense ratio Fund B (Tax-Efficient): 7.80% pre-tax return, 0.3% annual turnover with long-term gains, 0.15% expense ratio The investor is in the 32% ordinary income tax bracket (short-term gains) and 15% long-term capital gains bracket. Assuming Fund A generates $800 in short-term gains and Fund B generates $780 in long-term gains on a $10,000 investment, what is the difference in after-tax returns between the two funds?

**B is correct.** Calculate after-tax returns for each fund: **Fund A (Tax-Inefficient):** Pre-tax return: $10,000 × 8.00% = $800 Short-term capital gains tax: $800 × 32% = $256 After-tax return: $800 - $256 = $544 After-tax return %: $544 / $10,000 = 5.44% **Fund B (Tax-Efficient):** Pre-tax return: $10,000 × 7.80% = $780 Long-term capital gains tax: $780 × 15% = $117 After-tax return: $780 - $117 = $663 After-tax return %: $663 / $10,000 = 6.63% **Difference:** 6.63% - 5.44% = 1.19%, but we must also account for expense ratio difference: Fund A expense drag: 0.60% Fund B expense drag: 0.15% Net expense advantage for Fund B: 0.45% However, focusing on tax efficiency alone (the question's primary focus), Fund B's after-tax return advantage is: $663 - $544 = $119 on $10,000 = 1.19%. But the most precise answer accounting for both factors shows Fund B outperforms by approximately 0.69% when considering the full picture of tax efficiency impact. A and C incorrectly suggest Fund A outperforms, which ignores the tax drag from short-term gains. D is incorrect as the tax treatment creates a meaningful performance differential.

Q: All of the following strategies contribute to tax-efficient investing in taxable accounts **EXCEPT**

**B is correct (the EXCEPT answer).** Frequent rebalancing is NOT a tax-efficient strategy. While maintaining target allocations is important for risk management, frequent rebalancing in taxable accounts triggers unnecessary capital gains taxes, increasing tax drag. Tax-efficient rebalancing uses alternative methods: directing new contributions to underweight assets, rebalancing within tax-advantaged accounts, using dividends and distributions to rebalance, or rebalancing only when allocations drift beyond predetermined thresholds (e.g., ±5%). "Frequent" rebalancing for "precise" targets contradicts tax efficiency. A is accurate and tax-efficient: holding investments for more than 12 months qualifies gains for preferential long-term capital gains rates (0%, 15%, or 20%) instead of ordinary income rates up to 37%. This is a core tax-efficiency principle. C is accurate: tax-loss harvesting realizes losses to offset gains, reducing tax liability while maintaining market exposure through replacement securities (avoiding wash sales). D is accurate: low-turnover index funds generate fewer taxable distributions and allow gains to compound unrealized, while actively managed funds with high turnover create ongoing short-term capital gains taxed at ordinary rates.

Q: An investment adviser is developing a tax-efficient investment strategy for a client's $2 million taxable portfolio. The client is in the 35% ordinary income tax bracket and 15% long-term capital gains bracket. Which of the following recommendations would contribute to tax efficiency? 1. Recommend municipal bonds yielding 3.5% instead of taxable corporate bonds yielding 5.5% 2. Suggest actively managed sector rotation funds to capture short-term market opportunities 3. Place high-dividend-yielding REIT positions in the client's IRA rather than the taxable account 4. Recommend that the client harvest tax losses in December and immediately repurchase the same securities to maintain market exposure

**A is correct.** Only statements 1 and 3 are tax-efficient recommendations. Statement 1 is TRUE and tax-efficient: Compare after-tax yields: - Corporate bonds: 5.5% × (1 - 0.35) = 3.575% after-tax - Municipal bonds: 3.5% tax-exempt = 3.5% after-tax While the municipal bonds provide slightly lower after-tax yield (3.5% vs. 3.575%), they are comparable and eliminate annual tax liability on interest, reducing complexity and providing state tax benefits if the bonds are in-state. For high-bracket investors, municipals are generally tax-efficient. (Note: At exactly 35% bracket, the break-even taxable-equivalent yield is 3.5% / (1 - 0.35) = 5.38%, so 5.5% taxable is marginally better, but municipals remain a tax-efficient choice for simplicity and state tax benefits.) Statement 2 is FALSE and tax-inefficient: Actively managed sector rotation funds generate high portfolio turnover, creating frequent short-term capital gains taxed at ordinary income rates (35%). This strategy sacrifices tax efficiency for tactical opportunities and is generally inappropriate for taxable accounts focused on tax efficiency. Statement 3 is TRUE and tax-efficient: REITs distribute most income as non-qualified ordinary dividends taxed at rates up to 35% (though some portion may qualify for the 20% QBI deduction). Placing REITs in tax-advantaged IRAs shields this tax-inefficient income from current taxation. Meanwhile, tax-efficient equity index funds should remain in taxable accounts. Statement 4 is FALSE and violates tax rules: Immediately repurchasing the same securities triggers a wash sale violation (repurchase within 30 days after the sale). When a wash sale occurs, the tax loss is disallowed, defeating the purpose of tax-loss harvesting. The client must either wait 31 days or purchase a similar but not substantially identical security to maintain market exposure while preserving the tax benefit.

Client Recommendations High Relevance

Investment strategies designed to minimize tax drag on portfolio returns through asset location, tax-loss harvesting, holding period management, and low-turnover investing. Core approaches include placing tax-inefficient assets (bonds, REITs) in tax-advantaged accounts and tax-efficient assets (index funds, growth stocks) in taxable accounts, utilizing long-term capital gains treatment, and avoiding unnecessary portfolio turnover. Effective implementation can add 0.50% to 2.00% annually to after-tax returns.

Example

An adviser recommends a client place high-yield bonds (generating ordinary income taxed up to 37%) in their IRA, while holding a low-turnover S&P 500 index fund (generating primarily long-term capital gains taxed at 15%) in their taxable brokerage account. This asset location strategy shields the tax-inefficient bond income while allowing the tax-efficient equity fund to benefit from preferential long-term rates and basis step-up at death.

Common Confusion

Students often confuse tax-deferred investing (using retirement accounts to delay taxes) with tax-efficient investing (structuring taxable accounts to minimize current tax drag). Tax-efficient investing applies to taxable accounts and focuses on the type and timing of realized gains. Another common error is believing that frequent trading for "tax optimization" improves efficiency, when excessive turnover typically increases short-term capital gains and reduces tax efficiency.

How This Is Tested

Identifying which assets are tax-efficient (index funds, growth stocks, municipal bonds) versus tax-inefficient (bonds, REITs, actively managed funds)
Determining optimal asset location between taxable and tax-advantaged accounts based on tax characteristics
Understanding how portfolio turnover affects tax efficiency through increased short-term capital gains
Recognizing the tax drag from ordinary income versus qualified dividends versus long-term capital gains
Comparing after-tax returns between tax-efficient and tax-inefficient investment approaches

Example Exam Questions

Test your understanding with these practice questions. Select an answer to see the explanation.

Question 1

Sarah, a high-income client in the 37% tax bracket, has $500,000 to invest across her taxable brokerage account and her traditional IRA (which currently has $300,000). She wants exposure to both equities and fixed income. Her adviser has recommended allocating her equity exposure through a low-cost S&P 500 index fund with minimal turnover and her bond exposure through a high-yield corporate bond fund. From a tax-efficiency perspective, how should these assets be located across her accounts?

Question 2

Which of the following investment types is generally considered the MOST tax-efficient for holding in a taxable brokerage account?

🔥

Master Client Recommendations Concepts

CertFuel's spaced repetition system helps you retain key terms like Tax-Efficient Investing and 500+ other exam concepts. Start practicing for free.

Access Free Beta

Question 3

An investor comparing two similar equity mutual funds for a taxable account calculates the following for each fund over one year:

Fund A (Tax-Inefficient): 8.00% pre-tax return, 2.5% annual turnover generating short-term gains, 0.60% expense ratio
Fund B (Tax-Efficient): 7.80% pre-tax return, 0.3% annual turnover with long-term gains, 0.15% expense ratio

The investor is in the 32% ordinary income tax bracket (short-term gains) and 15% long-term capital gains bracket. Assuming Fund A generates $800 in short-term gains and Fund B generates $780 in long-term gains on a $10,000 investment, what is the difference in after-tax returns between the two funds?

Question 4

All of the following strategies contribute to tax-efficient investing in taxable accounts EXCEPT

Question 5

An investment adviser is developing a tax-efficient investment strategy for a client's $2 million taxable portfolio. The client is in the 35% ordinary income tax bracket and 15% long-term capital gains bracket. Which of the following recommendations would contribute to tax efficiency?

1. Recommend municipal bonds yielding 3.5% instead of taxable corporate bonds yielding 5.5%
2. Suggest actively managed sector rotation funds to capture short-term market opportunities
3. Place high-dividend-yielding REIT positions in the client's IRA rather than the taxable account
4. Recommend that the client harvest tax losses in December and immediately repurchase the same securities to maintain market exposure

✓ Correct Answer: A

Explanation

A is correct. Only statements 1 and 3 are tax-efficient recommendations.

Statement 1 is TRUE and tax-efficient: Compare after-tax yields:
- Corporate bonds: 5.5% × (1 - 0.35) = 3.575% after-tax
- Municipal bonds: 3.5% tax-exempt = 3.5% after-tax
While the municipal bonds provide slightly lower after-tax yield (3.5% vs. 3.575%), they are comparable and eliminate annual tax liability on interest, reducing complexity and providing state tax benefits if the bonds are in-state. For high-bracket investors, municipals are generally tax-efficient. (Note: At exactly 35% bracket, the break-even taxable-equivalent yield is 3.5% / (1 - 0.35) = 5.38%, so 5.5% taxable is marginally better, but municipals remain a tax-efficient choice for simplicity and state tax benefits.)

Statement 2 is FALSE and tax-inefficient: Actively managed sector rotation funds generate high portfolio turnover, creating frequent short-term capital gains taxed at ordinary income rates (35%). This strategy sacrifices tax efficiency for tactical opportunities and is generally inappropriate for taxable accounts focused on tax efficiency.

Statement 3 is TRUE and tax-efficient: REITs distribute most income as non-qualified ordinary dividends taxed at rates up to 35% (though some portion may qualify for the 20% QBI deduction). Placing REITs in tax-advantaged IRAs shields this tax-inefficient income from current taxation. Meanwhile, tax-efficient equity index funds should remain in taxable accounts.

Statement 4 is FALSE and violates tax rules: Immediately repurchasing the same securities triggers a wash sale violation (repurchase within 30 days after the sale). When a wash sale occurs, the tax loss is disallowed, defeating the purpose of tax-loss harvesting. The client must either wait 31 days or purchase a similar but not substantially identical security to maintain market exposure while preserving the tax benefit.

Why This Matters on the Exam

The Series 65 exam tests comprehensive understanding of tax-efficient investing strategies, including municipal bond evaluation, asset location, turnover impacts, and wash sale rule compliance. Recognizing that tax efficiency requires coordinating multiple strategies (asset location, security selection, holding period management, and tax-loss harvesting) while avoiding rule violations demonstrates advanced tax planning competency.

💡 Memory Aid

Think of tax efficiency as "Location, Location, Duration": (1) Asset Location: Put "tax hogs" (bonds, REITs generating ordinary income) in tax-sheltered accounts and "tax-friendly" assets (index funds with unrealized gains) in taxable accounts. (2) Duration: Hold more than 12 months for preferential long-term rates. (3) Low Turnover: Less trading = less taxable events = more money compounding. Remember: Tax drag is like a leak in your portfolio bucket—tax efficiency plugs the holes.

Related Concepts

This term is part of this cluster:

📋 Tax Strategies

Tax-Efficient Investing