Tax efficiency is essential to maximizing returns. Due to the complexities of both investing and U.S. tax laws, many investors don’t understand how to manage their portfolio to minimize their tax burden.
Simply put, tax efficiency is a measure of how much of an investment’s return is left over after taxes are paid. The more that an investment relies on investment income-rather than a change in its price- to generate a return, the less tax- efficient it is to the investor. This article will detail common strategies for creating a more tax-efficient portfolio. It will discuss tools commonly overlooked by investors, which results in lower lifetime returns due to paying higher taxes.
Taxable, Tax-Deferred and Tax-Exempt Accounts
Before investors can take any steps toward tax-efficient investing, they must first determine how their accounts are structured under the law. Generally speaking, accounts can be taxable, tax deferred or ta exempt. For taxable accounts, investors must pay taxes on their investment income in the year it was received. Taxable accounts include individual and joint investment accounts, bank accounts and money market mutual funds. On the other hand, tax-deferred accounts shelter investments from taxes as long as they remain in the account. Any kind of retirement account- 401(k), IRA or Roth IRA-is a tax deferred account. For tax-exempt accounts such as Canada’s Tax-Free Saving Account, investors do not need to pay taxes even at withdrawal.
Both types of saving accounts have their advantages and disadvantages. As a general rule of thumb, tax efficient investment that are not tax efficient should be made in a tax-deferred or tax-exempt account – if an investor has one.
Know Your Bracket
Next, an investor must consider the pros and cons of tax-efficient investing. First, the investor needs to determine his marginal income tax bracket and whether it is subject to the alternative minimum tax. The higher the marginal bracket rate, the more important tax- efficient investment planning becomes. An investor in a 39.6% tax bracket receives more benefit from tax efficiency on a relative basis than an investor in a 15% bracket.
Once the investor identifies his bracket, he must be aware of the differences between taxes on current on capital gains. Current income is usually taxable at the investor’s bracket rate. Capital gains taxes are distinguished by being a gain and by being either short term (usually held less than one year) or long term (usually held more than one year).
Generally speaking, short-term capital gain rates are at the investor’s marginal tax bracket, and his long-term rates are at a preferential rate. If the latter is the case, then the investor needs to try to generate capital gains at the preferential longer-term rate.
Different asset classes like stocks and bonds are taxed differently in the United States and often play much different roles in the investor’s portfolio. Historically, investors purchased binds to provide an income stream for their portfolios, and bonds have generally enjoyed lower volatility or risk than stocks. The interest income from most bonds is taxable (municipal bonds are a tax-efficient vehicle at the Federal Tax level, however) and is, therefore, tax-inefficient to the investor in a higher tax bracket. Stocks are often purchased to provide a portfolio with growth or gains in their capital, as well as a current income stream from dividends.
As a rule, investors should put tax-inefficient investments in tax-deferred accounts, and tax-efficient investments in taxable accounts. But tax efficiency is a relative concept. with the exception of the lowest-quality bonds, no investment is completely tax-inefficient-yet some are clearly more tax-efficient than others. To underscore this hierarchy, we’ll now discuss the different kinds of investments in terms of their location on a tax-efficiency scale, moving in the direction of complete tax efficiency.