Tax efficiency focuses on optimizing financial decisions and investment strategies so that they legally net the least amount of tax responsibilities. Depending on the financial goals and local tax structures, investors can choose from various tax efficiency strategies, including the following three:

Asset Location - Different types of accounts have different tax treatments. Asset location involves strategically dividing investments among several accounts to maximize tax efficiency. For example, financial professionals may recommend holding tax-efficient investments, such as index mutual funds, stocks, and tax-exempt bonds, in taxable accounts and tax-inefficient investments, such as actively managed funds and taxable bonds, in non-taxable or tax-deferred accounts.

Tax-Advantaged Accounts - If eligible, investors can use tax-advantaged accounts, such as employer’s 401(k) plans and individual retirement accounts (IRAs), to increase their tax efficiency. While conditions vary by the specific account type, investors can make tax-deductible contributions to tax-advantaged accounts and grow the dividends and capital gains earned tax-deferred until they start withdrawing.

Tax-Loss Harvesting - This tax efficiency strategy refers to intentionally selling investments at a loss to reduce taxes. Investors only pay taxes on realized net capital gains or the amount gained after deducting any investment losses. Therefore, they can offset capital gains in certain investments and lower their overall tax liability by selling other investments at a loss. It is noteworthy that tax-harvesting is subject to rigorous rules and restrictions, which investors must familiarize themselves with before employing it.