The Easiest Way to Increase Investment Returns: Cut Taxes

Investors, especially retired investors, need to know how taxes dilute their investment returns and the actions they can take to optimize investment taxes.

Investors on average give up 2.14% of their investment returns to income taxes, according to a study by Russell Investments.

But investors in tax-managed investments pay only 0.92% of their returns in taxes. Too many people focus on reducing commissions and management fees while overlooking ways to reduce taxes on their investments.

Taxes are a bigger investment expense than most people realize, and reducing taxes is the surest, easiest way to increase after-tax investment returns.

While many analysts offer ideas for earning higher pre-tax investment returns, very few explain how to minimize the amount the government takes from taxable investment accounts.

Yet, the route for achieving those tax savings is clear. Unlike investments, the return from the tax strategies is guaranteed.

You don’t want to take investment actions solely for their tax savings. But when considering investment actions, you need to review their tax consequences and potential tax-reduction strategies before pulling the trigger.

Too many investors think of investment tax planning as year-end tax planning. They wait until late in the year to consider a few moves. They miss a lot of tax reduction opportunities during the year.

Investment tax planning can be lucrative when done all year. It’s not quite a free lunch, because it does involve some work. But good investment tax planning can pay off handsomely.

I’m still surprised at the number of people who don’t realize that there is a 0% tax bracket for long-term capital gains and qualified dividends and that the 0% bracket is available to many middle-income retirees.

I’ll call long-term capital gains and qualified dividends tax-favored investment income (TFII). Other types of income are ordinary income.

There’s a 0% tax rate on TFII for most taxpayers in the 10% or 12% income tax brackets. In 2025, the 12% bracket tops out at $96,950 of taxable income for married couples filing jointly and $48,475 for single taxpayers.

In 2025, the 0% rate on TFII applies for married couples filing jointly with taxable incomes up to $96,700. For unmarried taxpayers, the 0% rate applies to taxable incomes up to $48,350.

The maximum rate on TFII of 20% applies to married couples filing joint returns with taxable incomes of $600,051 and above and unmarried taxpayers with taxable incomes of $533,401 and higher. There’s a 15% rate on TFII for taxpayers who are between the 0% and 20% brackets.

Here’s how the different tax brackets can provide a 0% rate on TFII to retired taxpayers with substantial incomes.

Suppose Max and Rosie Profits are a married couple who file joint returns. They have $50,000 of taxable income before considering TFII. The 0% tax rate on TFII applies until their taxable income exceeds $96,700. The Profits could have up to $46,700 of TFII for the year that would be taxed at the 0% rate. Additional TFII would be taxed at 15%.

But their gross income can exceed $96,700 and they’ll still be in the 0% bracket for TFII.

The break points for the different tax rates are based on taxable income. Taxable income is what’s left after taking all your tax deductions and other breaks. Your gross income can be higher than these amounts, perhaps substantially higher.

For example, from gross income, you subtract either the standard deduction or your itemized expenses. The standard deduction in 2025 is $30,000 for a married couple filing jointly and $15,000 for a single taxpayer.

So, someone with a relatively high gross income still can benefit from the lower rates on TFII.

In addition, there are strategies that can keep more people in the 0% bracket or TFII. Tax loss harvesting is a key investment tax strategy and the one most used. It often is the essence of year-end tax planning for investors.

The strategy is simple. When an investment in a taxable account has a market value that’s less than its purchase price, consider selling the asset. The capital loss offsets any capital gains you recognize for the year. Plus, up to $3,000 of capital losses that exceed gains for the year can be deducted against other types of income. Any additional excess capital losses can be carried forward to future years.

You can sell an investment and deduct the loss even when you still like the investment if you avoid the “wash sale” rules. You can buy the asset back after more than 30 days pass, or you can buy a comparable asset that’s not substantially similar. More details about the wash sale rules are in the March 2023 issue of Retirement Watch.

Don’t wait until the last few months of the year the way most people do. Consider tax loss harvesting throughout the year. When the markets or one of your investments tumbles and generates a paper loss, consider whether a tactical tax sale is in order.

Tax loss harvesting isn’t the only strategy to consider.

When you’re raising cash to spend or need to reposition your portfolio, carefully consider which assets to sell. Ask two questions.

How long have you owned the investment? Ideally, in a taxable account you don’t sell an investment at a gain unless you’ve held it for more than one year. That gives you a tax-advantaged long-term capital gain, instead of a short-term capital gain that’s taxed as ordinary income.

How much is the gain? When you’re selling investments to generate cash, it’s often best to sell assets with the lowest gains as a percentage of the sale price. The lower the gain as a percentage of the sale price, the more of the gain you’ll be able to spend after paying taxes. That also means you’ll have to sell less of the investment to generate the after-tax cash you’re seeking.

Of course, it’s best not to sell assets that have substantial capital gains unless there are capital losses to offset at least part of the gains.

Also, as discussed in this month’s Estate Watch, if you hold highly appreciated assets for life, your estate or heirs will increase the tax basis to the current fair market value. No one will have to pay capital gains taxes on the appreciation that occurred during your holding period.

Another strategy to optimize taxes is to review all the types of accounts you own before deciding on the source of a distribution.

Many people follow the old guidelines of drawing from taxable accounts first, tax-deferred accounts next, and tax-free accounts last. There are good reasons for those guidelines, but they don’t result in maximum after-tax cash flow for many people.

A better strategy is to estimate the amount of income you’re likely to have from all sources this year and where that income places you in the tax brackets.

Also, consider more than your income tax bracket. Consider your potential liability for the Stealth Taxes, such as the Medicare premium surtax, tax on Social Security benefits and others. See the May 2023 issue and Chapter 10 of my book, “Retirement Watch: The Essential Guide for Retiring in the 2020s,” for details about the Stealth Taxes.

If more taxable income might push you into the next higher tax bracket or increase Stealth Taxes, it’s probably not ideal to realize capital gains in a taxable account or take distributions from an ordinary IRA or 401(k).

Instead, if possible, take the extra cash you need from a tax-free account, such as a Roth IRA or a health savings account.

But in a year when your other income sources are low or you have a higher-than-usual amount deductions, consider taking the extra money you need from a traditional IRA or 401(k).

Of course, the investment fundamentals always come before tax considerations. But once you’ve made a decision to buy or sell investments or take IRA distributions, consider the tax implications before deciding on the timing and other factors.