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 tax 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 Savings Account, investors do not need to pay taxes even at withdrawal.
Both types of savings accounts have their advantages and disadvantages. As a general rule of thumb, tax-efficient investments should be made in the taxable account, and investments 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 income and taxes 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 bonds 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.
Among the most tax-inefficient investments are junk bonds. Due to their high risk of default, junk bonds typically pay higher yields than better-quality bonds to attract investors. Since junk bonds are used primarily as speculative instruments, they also pay higher yields than other types of bonds. Consequently, the yields paid to junk-bond investors are taxed at the same rate as ordinary income.
Straight-preferred stocks are relatively tax-inefficient. Generally considered hybrid instruments, straight-preferred stocks share characteristics of both common stocks and bonds. Like common stocks, straight-preferred stocks are issued in perpetuity; like bonds, they yield fixed payments, which provide downside protection, but limited upside potential. In addition, straight-preferred stockholders, like bond holders, are paid ahead of common stockholders.
Due to their bond-like qualities and fixed payment, straight-preferred stocks are taxed at the same rate as ordinary income. Although institutional investors, which are the primary market for preferred stocks, may largely offset their tax bill using the dividend received deduction (DRD); this tax credit is unavailable to individual investors. As with junk bonds, individuals must apply the current income tax rate to their dividend income from straight-preferred stocks.
Some straight-preferred stock is convertible to a pre-determined number of the issuer's common stock. The stockholder may decide to exercise this option at any time, enabling him to first lock in the fixed dividend payouts and then participate in the capital appreciation of the common stock. In exchange for this flexibility, the issuer usually pays lower dividends on convertible preferred stocks than on its straight-preferred stocks.
Dividends from convertible preferred stocks are considered ordinary income and taxed as such, unless the securities are converted to common stock. Therefore, convertible preferred stocks are hardly more tax-efficient than straight-preferred stocks - although investors may dramatically increase their tax efficiency by converting their holdings to common stocks, which are taxed at the lower long-term capital gains rate.
By comparison, convertible bonds are relatively tax-efficient. Not only do they usually have lower yields - and therefore incur fewer taxes - than junk bonds or preferred stocks, but bondholders may hold them in tax-deferred accounts. To achieve improved growth in capital gains, investors may convert these bonds into the issuer's common stock.
Next are investment-grade corporate bonds. Investors may also put them in tax-deferred accounts, making them a relatively low-cost and liquid means of gaining exposure to the bond market while also lowering their tax profile.
Even more tax efficient are common stocks, which are among the most tax-efficient investments, particularly when held in tax-deferred accounts. This is primarily because they are taxed at the long-term capital gains rate if held more than one year. Most tax efficient are municipal bonds due to their exemption from federal taxes. Yet because they have lower yields than investment-grade bonds, municipal bonds often represent a substantial opportunity cost for investors.
Real estate investment trusts (REITs) offer tax-efficient exposure to the real estate market. At the trust level, REITs are tax exempt provided they pay at least 90% of their profits to shareholders, while investors must pay ordinary income tax on their dividends and on shares bought and sold. However, REIT shares are taxed only after they earn back that part of the investment used to finance real estate purchases and improvements. Consequently, investors may time their tax liability for their REIT shares or in some years avoid taxes altogether.
The Bottom Line
Tax-efficiency is within reach of most investors. If you want to keep more of your investment earnings and stay out of a higher tax bracket, choose investments that offer the lowest tax burdens relative to their interest income or dividend income.
You may also want to consider your opportunities for investing tax-free. Given the markets' persistent volatility, your decisions regarding tax-efficient investing may spell the difference between reaching and falling short of your financial goals.
If you are looking for more information about tax exempt investments, Investopedia's Ask an Advisor tackles the topic by answering one of our user questions.