5 Signs Your Portfolio Isn’t Tax Efficient

Taxes are an unavoidable part of investing. Managing them correctly can help you minimize costs and maximize returns. A tax-inefficient portfolio, however, can erode your returns and limit your long-term growth.

How can you tell if your portfolio isn’t tax-optimized? There are several signs, including not following best practices and using a strategy that doesn’t fit your situation. In this article, we’ll share five key indicators of tax inefficiency, with expert insights from financial advisors on how to identify and resolve them.

1. You’re Paying Too Much in Capital Gains Taxes

Whenever you sell an asset for a profit, you must pay long- or short-term capital gains taxes. While some taxes are inevitable, poor portfolio construction can cause you to pay more than necessary.

“A clear sign [of poor tax efficiency] is receiving large annual tax bills from capital gains distributions, even in years when the portfolio underperformed,” says Chris Tipton, CFP^®, CFS^®, ChFC^®, senior advisor at Balefire.

This problem often shows up when investors hold actively managed mutual funds in taxable accounts. These funds may realize and distribute gains throughout the year, even if you didn’t sell anything, creating an unexpected tax liability.

A solution is to hold mutual funds in tax-advantaged accounts, like a traditional IRA or Roth IRA. This setup works well for long-term investors because it defers taxes until retirement when withdrawals incur ordinary income taxes.

2. You’re Neglecting Tax-Loss Harvesting

Another sign of tax-inefficient investing is overlooking the advantages of tax-loss harvesting. This powerful strategy aims to offset gains in your portfolio by selling losing assets and reinvesting the proceeds into similar ones, allowing you to pay taxes only on your net capital gains.

“Tax-loss harvesting can offset gains and reduce taxable income, but many investors either don’t know it’s an option or miss the timing to take advantage,” Tipton explains.

Beyond the tax benefit, harvesting losses gives you the chance to reinvest into similar (but not identical) assets that may better align with your goals. It can also support risk management and rebalancing over time.

A crucial component of tax-loss harvesting is understanding the wash-sale rule. This IRS regulation disallows a tax deduction if you repurchase the same or substantially identical security within 30 days before or after the sale.

“Investors may not realize it but wash sale rules disallow you from capturing a loss in your brokerage account after buying that same security in your IRA or any of your spouse’s accounts within 30 days,” says Kristen Kuzma, CFP^®, wealth manager at Fairway Wealth Management, LLC.

Because tax-loss harvesting requires careful attention and expertise, it’s vital to consult with an advisor before adopting it. A professional can help you avoid common mistakes—such as not following the wash-sale rule—so you can maximize the strategy.

3. You’re Generating Ordinary Income in the Wrong Accounts

While a good result, generating income with your investments can spell bad news for your tax situation, depending on the account. Consequently, this is especially true for assets that produce ordinary income, such as:

• Dividend-paying stocks
• Corporate bonds
• Real estate investment trusts (REITs)

Unlike long-term capital gains taxes, ordinary income is typically taxable at a higher rate. Keeping assets like the above in a taxable brokerage account exposes you to a higher tax hit than if you had them in a tax-deferred or tax-free account, such as a traditional or Roth IRA, respectively.

A central part of this issue is “generating interest income and ordinary dividends during your prime earning years—on top of already high salary or business income,” says Jing Zheng, founder and financial planner at Neat Financial Planning, LLC. Keeping assets like this in a taxable account as a high earner can compound into a much larger tax burden. “This often means you’re investing in safer, income-producing assets like bonds or dividend stocks in a taxable account, rather than focusing on long-term growth,” she adds.

In taxable accounts, Zheng generally recommends a “mix of stock funds that pay mostly qualified dividends or focus on long-term growth, along with fixed income funds in the Treasury or municipal bond sectors for tax efficiency.” Meanwhile, income-generating investments (namely, those listed above) may fit in tax-deferred accounts.

What you invest in is critical, but where you keep those holdings also matters. As you buy assets, align the tax characteristics of the account with them to ensure optimal efficiency and progress toward your goals.

4. You’re Selling the Wrong Investments at the Wrong Time

Buying low and selling high sounds simple in theory, but in practice, many investors hurt themselves by selling at tax-inefficient times. The time you sell an asset can both increase your tax liability and impact your portfolio’s performance.

Zheng notes a common issue she sees is “frequently selling your winners and holding losers ‘patiently.’” Investors may relinquish well-performing assets sooner, triggering capital gains taxes. It may also be tempting to hold onto poor performers, hoping they’ll succeed.

“Yes, it feels good to take home some profits,” Zheng says, “but you’re also paying taxes right away and giving up your market position. If you’re getting right back into the market, then why trim the profits and pay the taxes?”

Selling too early can be especially detrimental in a brokerage account. If you move off an asset too quickly, you could sustain short-term capital gains tax at your normal ordinary income rate. Conversely, holding on to losers indefinitely prevents you from selling them as a way of strategically offsetting gains with tax-loss harvesting.

Whenever you muse about selling or retaining an asset, consider the implications across your entire portfolio. Decisions are stronger with intent and context, rather than emotion or uncertainty.

5. You’re Not Regularly Reviewing Your Tax Strategy

Even a well-built portfolio can become tax-inefficient over time if hasn’t been monitored. Lots can change over time, including market volatility, tax laws, and your life situation (income, tax rate, time horizon, etc.). All of these factors make regular attention to your tax strategy even more crucial.

“At a minimum, tax strategy should be reviewed annually,” says Tipton. “But ideally, it’s done quarterly—especially during volatile markets, when tax-loss harvesting opportunities may arise unexpectedly,” he adds.

Similarly, Kuzma recommends considering tax optimization “when implementing trades, whether that’s during a tax loss harvesting opportunity, investing new money, or while routinely rebalancing.” Additionally, she says that it’s worth revisiting your strategy if you “receive an unexpected tax bill due to investment income.”

Regularly reviewing your tax strategy can help you identify opportunities for improvement or proactive tax-loss harvesting. You’ll also be more aware of why you may or may not owe taxes at a given time, minimizing stress and helping you feel more in control of your portfolio.

Bottom Line

While not immediately apparent, a tax-inefficient portfolio can compound into unnecessary costs and reduce progress toward long-term goals. Following best practices and regularly reviewing your strategy, however, can help stave off these negatives. Moreover, signs such as those above are necessary to look for during regular audits of your portfolio.

If you feel like you’re unsure whether your portfolio is efficient or not, it may be a good time to speak with a financial advisor. The right expert can help identify gaps and tailor a strategy that fits your goals and timeline.

To get started, consider using this free matching tool, which connects you with a vetted fiduciary advisor based on your unique needs.