Tax efficiency is essential to maximizing investment returns. Unfortunately, the complexities of both investing and the U.S. tax laws prevent many investors from understanding how to manage their portfolios to minimize the tax burden.
Put bluntly, tax efficiency is a measure of how much of an investment's profit is left over after the taxes are paid.
The more an investment relies on investment income rather than a change in its market price to generate a return, the less tax-efficient it is for the investor.
Generally, the higher your tax bracket rate is, the more important tax-efficient investing becomes.
That said, what follows are some of the common strategies for creating a more tax-efficient portfolio.
Taxable, Tax-Deferred, and Tax-Exempt
Generally speaking, investments can be taxable, tax-deferred, or tax-exempt. The first step toward tax-efficient investing is to determine how your investments are structured under the law:
- If the investment is taxable, the investor must pay taxes on the investment income in the year it was received. Taxable accounts include individual and joint investment accounts, bank accounts, and money market mutual funds.
- If the account is tax-deferred, the money is sheltered from taxation as long as it remains in the account. Traditional IRAs and 401(k) accounts are examples of tax-deferred savings.
- For tax-exempt accounts, such as municipal bonds and Canada's Tax-Free Savings Account (TFSA), investors do not need to pay federal taxes even when the money is withdrawn.
Each has its advantages and disadvantages. As a rule of thumb, tax-efficient investments should be made in a taxable account, and investments that are not tax-efficient should be made in a tax-deferred or tax-exempt account. Granted, not everyone has both.
A Beginner’s Guide To Tax-Efficient Investing
Know Your Bracket
Next, the investor must consider the pros and cons of tax-efficient investing and that depends most of all on the person's income tax bracket. The higher the marginal bracket rate, the more important tax-efficient investing becomes. An investor in the highest 37% tax bracket receives more benefit from tax efficiency on a relative basis than an investor in the 10% or 12% bracket.
The high-income investor also needs to know whether the alternative minimum tax (ATM) applies. For the 2019 tax year, the ATM will be 28% for married couples reporting income over $194,800, or $97,400 for individual filers.
Current Income vs. Capital Gains
Next, the investor must be aware of the difference between taxes on current income and taxes on capital gains.
Most current income is taxable at the investor's tax bracket. Capital gains on investments held for at least a year are currently taxed between 0% and 15%, depending on the filer's tax bracket.
Note that the low capital gains tax is available only if the investment is held for a year or more. Less than that, and those gains are treated like regular income. Clearly, the tax-savvy investor buys stocks and other investments intending to hold them for a year at least.
Stocks vs. Bonds
Different asset classes, such as stocks and bonds, are taxed differently in the U.S., and that's one reason why they play different roles in most investors' portfolios.
Highly-rated bonds are relatively safe investments that can provide a steady if unspectacular income in interest payments for the investor. The interest income from most bonds is taxable, though municipal bonds are tax-exempt at the federal level and sometimes at the state level. That makes municipal bonds a tax-efficient choice for the investor in a higher tax bracket.
- Some tax-efficient investments include stocks held long-term and municipal bonds.
- Tax-inefficient investments include junk bonds and REITs.
- Generally, investment income is taxed at a higher rate than investment gains.
Stocks can provide a portfolio with greater growth over time as well as an income stream from dividends. The tax benefits are substantial if they're held long-term. Along with those benefits comes a much bigger risk of price volatility.
Given all of the above, few investments in the U.S. can be called truly tax-inefficient. But there are exceptions.
Among the most tax-inefficient investments are junk bonds. If that doesn't scare off most investors, the name should give it away. These are low-quality bonds issued by companies and governments deemed to be at high risk of defaulting on their debts.
Junk bonds typically pay bigger yields than high-quality bonds in order to attract investors. As such, they are considered to be speculative investments and are taxed as ordinary income.
Straight-preferred stocks are another relatively tax-inefficient investment. Generally considered hybrid instruments, straight-preferred stocks share some characteristics of both common stocks and bonds. Like common stocks, straight-preferred stocks are issued in perpetuity. Like bonds, they yield fixed payments. That means they have some protection from losses but limited potential for growth.
Income from straight-preferred stocks is taxed at the same rate as ordinary income. (Institutional investors, the primary market for preferred stocks, offset their tax bills using the dividends received deduction (DRD). This tax credit is not available to individual investors.)
Convertible Preferred Stock
Some straight-preferred stock is convertible to a set number of the issuer's common shares. The stockholder may decide to exercise this option at any time, first locking in the fixed dividend payouts and then participating in the capital appreciation of the common stock.
In exchange for this flexibility, the issuer usually pays lower dividends on its convertible preferred stocks than on its straight-preferred stocks.
Dividends from all convertible preferred stocks are considered ordinary income and taxed as such unless the securities are converted to common stock. Convertible preferred stocks are thus hardly more tax-efficient than straight-preferred stocks, although investors may dramatically increase their tax efficiency by converting their holdings to common stocks.
By comparison, convertible bonds are relatively tax efficient. They may have lower yields than junk bonds or preferred stocks, but convertible bonds can be held in tax-deferred accounts. To achieve improved growth in capital gains, the investor may convert these bonds into shares of common stock.
Corporate Bonds and Common Stocks
Next are investment-grade corporate bonds. Investors may put them in tax-deferred accounts, making them a relatively low-cost and liquid means of gaining exposure to the bond market while lowering their tax profiles.
Even more tax-efficient are common stocks, which are among the most tax-efficient investments, particularly when held in tax-deferred accounts. Just don't make the mistake of selling them within a year and the gains are subject to minimal taxes.
Municipal Bonds and REITs
Most tax-efficient of all are municipal bonds, due to their exemption from federal taxes. They generally have lower yields than investment-grade bonds.
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, but investors must pay ordinary income tax on 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 the tax liability for their REIT shares or, in some years, avoid taxes altogether.