If You Have This Type Of Portfolio, You're A Smart Investor

The old adage that nothing in life is certain except death and taxes might be cliché, but it's also largely true. With this is mind, not knowing how your investments are taxed can be a big mistake to your bottom line. Whether you're at an age where your portfolio is focused on aggressive growth or you've reached the age at which portfolio stability is more important, you're a smart investor if you have a tax-efficient investment portfolio.

Taxable investments are income sources that require you to pay taxes through either capital gains or dividends. Per the IRS, most capital gains won't exceed a 15% tax, but the rate can range from 0% to as high as 28% — depending on things like the kind of investment, how long you've held the asset, and your income level. Meanwhile, dividends are either qualified or non-qualified and will be taxed accordingly. Qualified dividends generally have a lower tax rate — using the long-term capital gains tax rate of between 0% and 20% – making them a more tax-efficient option for a portfolio, while non-qualified dividends are taxed at your personal marginal federal income tax rate (anywhere from 10% to 37%).

Tax-deferred and tax-exempt accounts can also provide excellent tax advantages that taxable investments don't offer. Having at least a portion of your portfolio dedicated to these types of investments often means paying less in taxes, either because you're in a lower tax bracket when taxes are due or you've already paid taxes on the contributions.

Tax-efficient investments come in many forms, and working alongside a trusted financial planner can help you make strategic moves with your money so you pay the least amount in taxes. For some, maxing out 401(k) contributions can be an excellent strategy for a tax-efficient portfolio. This is because you don't generally have to pay taxes on 401(k) contributions until you begin making withdrawals — which typically only happens once you retire and are potentially in a lower tax bracket.

Other good tax-efficient investing options are Roth IRAs and Roth 401(k)s. With these, you pay taxes on contributions upfront, meaning your eventual withdrawals aren't taxed — as long as they're made after you turn 59 ½. Municipal bonds also have tax advantages, with these bond types coming with tax-free income at the federal level, while state and local taxes can also sometimes be avoided.

ETFs and money market accounts might also offer tax advantages under the right circumstances. For instance, a tax-exempt money market fund that invests heavily in municipal bonds can provide federal tax exemptions as though you invested directly in the municipal bonds yourself. ETFs, on the other hand, are subject to capital gains taxes after the investment is sold, and you'll pay taxes on dividends, though at a lower qualified rate. However, ETF managers typically reduce tax exposure through strategic allocations designed to reduce your tax burden.

As with all types of investing, there are risks associated with structuring a tax-efficient portfolio. Your goals should ultimately play a major role in your overall investment strategy — and avoiding or limiting taxes should only be one part of your overall focus. Your risk tolerance can also guide just how much of your portfolio to dedicate to tax-efficient investments. In general, low-risk investments typically don't have the same earnings potential that riskier investments offer. For instance, while municipal bonds are tax-efficient, they also tend to come with lower interest rates. In fact, this premise can be relevant to many tax-efficient investment options so knowing your specific goals can keep you on the right path.

This is why a diversified portfolio can be the key to ensuring you have well-rounded sources of investment income in both safe, tax-efficient ways alongside higher-risk, higher-reward avenues. Being in tune with what your stock portfolio should look like at, say, 40 compared to what it should look like at age 60 could provide the information you need to make the best investments at every stage of life.