By Zoltan Pongracz, CFP, ChFC, CLU, AIF, Forbes Councils Member.

Say you earn 15% in a high-turnover hedge fund that generates significant short-term capital gains, or you earn 15% in a tax-efficient investment. Those may look like the same return on paper, but they can produce vastly different outcomes in terms of what you actually keep. Especially if you’re in a high-tax state like New York, a 15% pre-tax return could end up closer to 7% to 8% after taxes.​

That’s because short-term capital gains are taxed as ordinary income. For someone in the top brackets, taxes can collectively consume more than half of that return. That doesn’t mean the hedge fund is necessarily a bad investment or should automatically be eliminated from the portfolio. It means the tax impact needs to be part of the decision-making process when deciding whether to make (or continue holding) an investment.​

When it comes to investing, people tend to focus on the headline return, but what matters is what they keep. With thoughtful planning, proper asset location and tax-management strategies, investors can reduce unnecessary tax drag and increase the amount of their investment returns that ultimately contributes to their net worth.​

Why Tax-Aware Investing Matters

Taxes can be one of the biggest drags on long-term investment returns.​ What we often see with new clients is a cobbled-together investment portfolio that was built through accumulation rather than around a cohesive strategy. The individual pieces may be perfectly reasonable on their own, but they don’t necessarily work well together from a tax perspective.​

One of the primary purposes of a financial plan is to coordinate those different pieces so the portfolio works as a whole, including making sure investments are structured and located in a tax-efficient way.​ Tax-aware investing is about focusing on what you keep, not just what you earn.

There are a few different components of tax-aware investing that we focus on:

1. Asset Location

It’s not just what you own, it’s where you own it. Tax-inefficient investments like taxable bonds, private credit or high-turnover strategies are often better suited for IRAs and other tax-advantaged accounts. More tax-efficient investments, such as broad-market ETFs and municipal bonds, are generally better candidates for taxable accounts.​

2. Direct Indexing

For clients where it makes sense, instead of buying an S&P 500 ETF as a single line-item, you can own the individual stocks that make up the index. You get similar market exposure, but each position can be managed individually, creating more opportunities for tax-loss harvesting.​

3. Tax-Loss Harvesting

Tax-loss harvesting means selling an investment that has declined in value, realizing the loss for tax purposes and reinvesting the proceeds into a similar investment so you remain invested. That realized loss can then be used to offset capital gains elsewhere in the portfolio.​

The Tax Mistakes We See Most Often

1. Owning The Right Things In The Wrong Accounts

We’ve reviewed portfolios where municipal bonds, for example, were held in an IRA for no good reason. The primary benefit of municipal bonds is their tax-exempt income, which provides little value inside an account that is already tax-advantaged. That’s a straightforward example of why asset location matters.

Now take the hedge fund example from earlier: If a strategy is generating strong returns but also producing significant short-term capital gains, can it be held in an IRA or Roth IRA instead?

2. Waiting Until December

A lot of advisors and clients wait until year-end to harvest losses and think about taxes. Or, they just walk into their CPA’s office in March and ask what they owe. The IRS is a partner in your taxable accounts the entire year and, as such, should be thought about throughout the entire year.​

3. Blindly Rebalancing

If you’re targeting a 60/40 mix of stocks and bonds for example and a strong equity market pushes you closer to 70/30, you may need to rebalance. The mistake is doing that mechanically and realizing unnecessary capital gains in the process.

Instead, you may be able to use new cash contributions, direct withdrawals from appreciated positions or adjust elsewhere in the portfolio to move back toward your target allocation in a more tax-efficient way.​​

4. Holding Tax-Inefficient Mutual Funds In Taxable Accounts

Actively managed mutual funds can create tax bills you don’t fully control. The fund may sell appreciated holdings because of redemptions, rebalancing or changes in the portfolio, and those realized gains can be distributed to shareholders. So even if you personally never sold a share, you may still receive a taxable capital-gain distribution. In some cases, you can even lose money in the fund over the year and still owe taxes.​

One potential solution is a separately managed account (SMA). You still get professional portfolio management, but unlike a mutual fund, you directly own the underlying securities. That gives you much more control over taxes: Losses can be harvested at the individual security level, gains can be managed more intentionally, and the actions of other investors don’t create a capital-gains distribution.

Signals It’s Time To Evaluate Your Investing Strategies

There are certain situations where it makes sense to take a closer look at how taxes are affecting your investment decisions and overall financial plan:

• You sold a business, or plan to, and are facing a significant capital gain.

• You have substantial realized or unrealized capital gains this year.

• You own actively managed or tax-inefficient mutual funds in a taxable account.

• You hold income-producing investments, such as private credit or taxable fixed income, in taxable accounts without a compelling reason.

• Most of your tax planning happens after the year is already over.​

These are the types of situations we urge investors to evaluate as part of the broader financial planning and investment-management process.​

Tax-Aware, Not Tax-Driven

The thing investors have to keep in mind is to not let the tax-tail wag the dog. Don’t make a bad investment just to save taxes. The tax benefits can make a good investment great, but they’re not going to make a bad investment good.​

Be tax-aware, not tax-driven.​