Taxes are inevitable. You pay tax on essentially all of your income, including investment returns like interest, dividends, or realized gains. In any given year, it may not seem like a significant tax compared to the other income you earn, but over time, these taxes can eat away at your long-term investment gains. Fortunately, there are strategies for minimizing the tax drag on your investments and optimizing your portfolio.
Tax-Loss Harvesting
When you sell an investment like a stock or shares of a fund, you either realize a capital gain or loss depending on how the proceeds compare to your cost basis. On your individual tax return, gains are netted with losses. You pay income tax on net gains and can deduct up to $3,000 of capital loss against other income and carry forward any residual losses to future tax years.
Typically, the more you offset gains with losses, the less you’ll pay in income tax, a strategy called tax-loss harvesting. Review your portfolio holdings to assess if there are assets you can sell for a loss. If you’re worried about losing market position, use the proceeds to buy another investment to keep your hat in the game. Be careful not to buy back the same asset immediately, or you’ll fall victim to the wash sale rule. You must wait at least 30 days to buy back a substantially similar asset, or the IRS will disallow the loss.
Illustration
Investor A has realized gains of $15,000 so far in 2025. When the market dipped in April 2025, Investor A sold stock for a loss of $8,000 and bought a different company’s stock with the proceeds. If Investor A doesn’t sell any additional stock for the remainder of the year, he will realize a capital gain of $7,000 on his tax return instead of the original $15,000.
Tax-Advantaged Accounts
As the name suggests, using tax-advantaged accounts is another strategy to minimize tax on your investment returns. Typically, contributions to tax-advantaged accounts are tax-deferred, meaning they aren’t subject to income tax now. Instead, they are invested and grow tax-free until you decide to take distributions. Common tax-advantaged accounts include retirement accounts like 401(k)s and traditional IRAs, education savings accounts like 529 plans, and health care savings accounts like flexible spending accounts (FSAs) or health savings accounts (HSAs). HSAs are even triple-tax advantaged, meaning your contributions, investment returns, and distributions are tax-free if you use the funds for qualified medical expenses.
Illustration
Individual A earns a salary of $100,000 from her employer. In 2025, she contributes $18,000 to her traditional 401(k), so her 2025 taxable income from her employment is $82,000. With a tax rate of 22%, her federal income tax on her salary is $18,040. The $18,000 will grow in her account tax-free until she takes distributions.
If she opted not to contribute to her 401(k), her taxable income would be $100,000. At a rate of 22%, her federal tax would be $22,000.
Holding Long-term
Holding an asset for more than one year is considered long-term, and upon disposition, you realize either a long-term capital gain or loss. Most of your income, including short-term capital gains, is taxed at a rate ranging from 10% to 37% for individuals and calculated based on your filing status and taxable income. However, qualified dividends and long-term capital gains are subject to lower tax rates ranging from 0 to 20%. Accordingly, if you hold an asset longer, you may save in capital gains tax when you sell.
Illustration
Investor A owns 100 shares of ABC Company that she purchased in February 2024 for $32. In January 2025, she considers selling the stock when the price reaches $39 a share. She decides to wait and eventually sells in March 2025, when the share price is still $39.
If she sold in January, she’d realize a short-term gain of $700 subject to income tax at her federal ordinary income tax rate of 22% plus 3.8% of net investment income tax (NIIT). The federal income tax would have been $181 for a net profit of $519.
Since she sold in March 2024, the $700 gain is long-term and subject to income tax at 15% plus 3.8% of NIIT. The resulting tax is $131 for a net profit of $569.
Final Thoughts
While taxes are an unavoidable part of investing, employing these tax-efficient strategies can optimize your investment returns and help build your wealth.
