Opens in a new windowInvesting your money in retirement accounts like 401(k)s or in the market with mutual funds can be a great way for you to nurture the nest egg you’ve worked so hard to build for you and your family.

However, you may be leaving money on the table if you’re not accounting for how your investments are taxed from the get-go.

Here’s what you need to know about tax-efficient investing to make sure you’re maximizing your gains: 

What is tax-efficient investing?

Tax-efficient investing means choosing investments and account types that help reduce the taxes you owe on gains and income. The goal is to maximize your after-tax returns.

Benefits include:

• Lower taxes on gains and distributions
• Potential for tax-free, tax-deferred, or lower-rate taxable income
• More money stays invested and continues to grow

How are investments taxed?

1. Capital Gains

Capital gains occur when you sell an investment for more than you paid for it.

• Short-term capital gains
  • Applies to assets held for one year or less
  • Taxed at your ordinary income tax rate, which can be as high as 37%
• Long-term capital gains
  • Applies to assets held for more than one year
  • Taxed at preferential rates: 0%, 15%, or 20%, depending on your income level

Example:
If you buy a stock for $1,000 and sell it a year later for $1,500:

• If held for less than a year, the $500 gain is taxed as ordinary income.
• If held for more than a year, the $500 gain is taxed at the long-term capital gains rate.

2. Dividends

Dividends are payments made by companies to shareholders, and they’re taxable in the year received—even if reinvested.

• Qualified dividends
  • Paid by U.S. corporations or qualified foreign companies
  • Held for a minimum period (typically 60+ days)
  • Taxed at long-term capital gains rates
• Ordinary (non-qualified) dividends
  • Taxed at your ordinary income tax rate

Example:
If you receive $200 in qualified dividends and you’re in the 15% capital gains bracket, you’ll owe $30 in taxes.

3. Mutual Funds and ETFs

Even if you don’t sell your shares, you may owe taxes due to fund activity.

• Mutual funds
  • Fund managers may sell securities within the fund, triggering capital gains
  • These gains are distributed to shareholders and are taxable
• ETFs (Exchange-Traded Funds)
  • Generally more tax-efficient due to “in-kind” redemption process
  • Fewer taxable events passed onto shareholders

4. Reinvested Earnings

Reinvesting dividends or capital gains doesn’t shield you from taxes.

• You still owe taxes on reinvested amounts in taxable accounts
• These reinvested amounts increase your cost basis, which can reduce future capital gains

5. Taxable vs. Tax-Deferred Accounts

Where your investments are held also affects taxation:

• Taxable accounts
  • You pay taxes annually on dividends and realized gains
• Tax-deferred accounts (e.g., IRAs, 401(k)s)
  • No taxes on gains or dividends until withdrawal
  • Withdrawals are taxed as ordinary income

Why use tax-advantaged accounts?

Accounts like IRAs and 401(k)s offer built-in tax benefits that can help your investments grow more efficiently.

Traditional IRA or 401(k):

• Contributions may be tax-deductible (IRA) or pre-tax (401(k))
• Investments grow tax-deferred
• No taxes on dividends or gains until withdrawal
• Withdrawals after age 59½ are taxed as ordinary income
• Early withdrawals may incur a 10% penalty (with some exceptions)

What are some strategies for taxable accounts?

Even in taxable accounts, you can reduce your tax burden with smart strategies.

Consider:

• ETFs over mutual funds: ETFs are generally more tax-efficient because they don’t require fund managers to sell assets when investors exit.
• Tax-loss harvesting: Sell investments that have lost value to offset gains elsewhere in your portfolio and reduce your taxable income.

DISCLOSURES:

The Prudential Insurance Company of America, Newark, NJ. Prudential does not provide tax or legal advice. This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation about managing or investing your retirement savings. If you would like information about your particular investment needs, please contact a financial professional.

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