What Is Tax Efficiency?
Tax efficiency is an attempt to minimize tax liability when given many different financial decisions. A financial decision is said to be tax efficient if the tax outcome is lower than an alternative financial structure that achieves the same end.
Understanding Tax Efficiency
Tax efficiency refers to structuring an investment so that it receives the least possible taxation. There are a variety of ways to obtain tax efficiency when investing in the public markets.
Tax-Deferred and Tax-Free Accounts
A tax payer can make income-producing investments in a tax-deferred account, such as an Individual Retirement Arrangement (IRA), 401(k) plan, and annuity. Any dividends or capital gains earned from the investments are automatically reinvested in the account which continues to grow tax-deferred until withdrawals are made.
Tax-Efficient Mutual Fund
Investing in a tax-efficient mutual fund, especially for taxpayers that don’t have a tax-deferred or tax-free account, is another way to reduce tax liability. A tax-efficient mutual fund is taxed at a lower rate relative to other mutual funds. These funds will generate lower relative levels of dividends and/or capital gains compared to the average mutual fund. Small-cap stock funds and funds that are passively-managed, such as index funds and exchange-traded funds (ETFs), are good examples of mutual funds that generate little to no interest income or dividends.
Long-Term Capital Gains/Losses
Also, a taxpayer can achieve tax efficiency by holding stocks for more than a year which will subject the investor to the more favorable long-term capital gains rate, rather than the ordinary income tax rate that is applied to investments held for less than a year. In addition, offsetting taxable capital gains with current or past capital losses can reduce the amount of investment profit that is taxed.
A bond investor can opt for municipal bonds over corporate bonds, given that the former is exempt from taxes at the federal level. If the investor purchases a muni bond issued in his state of residency, the coupon payments made on the bond may also be exempt from state taxes.
For estate planning purposes, the irrevocable trust is useful for people who want to gain estate tax efficiency. When an individual holds assets into this type of trust, s/he surrenders incidents of ownership, because s/he cannot revoke the trust and take back the resources. As a result, when an irrevocable trust is funded, the property owner is, in effect, removing the assets from his or her taxable estate. Generation-skipping trusts, qualified personal residence trusts, grantor retained annuity trusts (GRAT), charitable lead trusts, and charitable remainder trusts are some of the irrevocable trusts that are used for estate tax efficiency purposes. On the other hand, a revocable trust is not tax-efficient because the trust can be revoked and, thus, assets held in it are still part of the estate for tax purposes.
These strategies for achieving tax efficiency are by no means an exhaustive list. Financial professionals can help individuals and businesses assess the best ways to reduce their tax liabilities.
Investors in high tax brackets are often more interested in tax-efficient investing because their potential savings are more significant. However, choosing the best tax-efficient investment can be a daunting task for those with little knowledge of the different types of products available. The best decision may be to contact a financial professional to determine if there is a way to make investments more tax efficient.