What Is Tax Efficiency?
Tax efficiency is when an individual or business pays the least amount of taxes required by law. 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.
- Tax efficiency is when an individual or business pays the least amount of taxes required by law.
- A taxpayer can open income-producing accounts that are tax-deferred, such as an Individual Retirement Account (IRA) or a 401(k) plan.
- Tax-efficient mutual funds are taxed at a lower rate relative to other mutual funds.
- A bond investor can opt for municipal bonds, which are exempt from federal taxes.
- An investor can also opt for an irrevocable trust to gain estate tax efficiency.
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.
A taxpayer can open an income-producing account whereby the investment income is tax-deferred, such as an Individual Retirement Account (IRA), a 401(k) plan, or an 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.
With a traditional retirement account, the investor gets tax savings by reducing the current year's income by the amount of funds placed in the account. In other words, there's an upfront tax benefit, but when the funds are withdrawn in retirement, the investor must pay taxes on the distribution. On the other hand, Roth IRAs do not provide the upfront tax break from depositing the funds. However, Roth IRAs allow the investor to withdraw the funds tax-free in retirement.
Changes to Retirement Accounts Starting in 2020
In 2019, changes were made to the rules regarding retirement accounts with the passage of the SECURE Act by the U.S. Congress. Below are a few of those changes that took effect in 2020.
If you have an annuity in your retirement plan, the new ruling allows the annuity to be portable. So, if you leave your job to take another job at another company, your 401(k) annuity can be rolled over into the plan at your new company. However, the new law removed some of the legal liabilities that annuity providers previously faced by reducing the ability of account holders to sue them if the provider fails to honor the annuity payments.
For those with tax-planning strategies that include leaving money to beneficiaries, the new ruling may impact you too. The SECURE Act removed the stretch provision, which allowed non-spousal beneficiaries to take only the required minimum distributions (RMDs) from an inherited IRA. Starting in 2020, non-spousal beneficiaries that inherit an IRA must withdraw all of the funds within ten years following the death of the owner. The good news is that investors of any age can now add money to a traditional IRA and get a tax deduction since the Act removed the age limitation for IRA contributions.
There have also been several recent changes to required minimum distributions. Originally, RMDs don't need to begin until age 70 1/2. As part of the SECURE Act, this age limit was increased to 72. Then, as part of the SECURE 2.0 Act, the age was again increased to 73. As of February 2023, this is where the RMD age stands.
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 typically generate lower rates of returns through dividends 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 and Losses
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 their 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, they surrender incidents of ownership, because they 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 their 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.
How Do You Calculate Tax Efficiency?
You can calculate tax efficiency by subtracting the amount of tax paid from the return to determine net return. Then, divide the net return by the gross return. This proportion will show how much of income an individual retains. The higher the proportion, the more tax efficient a taxpayer is.
How Can I Increase My Tax Efficiency?
The most obvious and direct way to become tax efficient is to utilize appropriate investment vehicles. This means contributing to your employer's 401(k) account, leveraging individual retirement accounts, or exploring other means of deferring or avoiding taxes. You can also increase tax efficiency by gifting appreciating assets as opposed to selling and recognizing a capital gain.
Is Tax Efficiency Ethical?
Some people feel that tax efficiency, especially when captured by high net worth individuals, is not fair. Consider a billionaire that pays a lower total effective tax rate than someone in poverty. As long as they conform to the rules outlined by the IRS, they are technically not doing anything illegal. Therefore, some may argue that tax efficiency is an unethical way of finding tax loopholes to maneuver out of liability. In any case, there is nothing legally wrong with tax efficiency.
The Bottom Line
Individual taxpayers may be incentivized to make the most of their money. One way of doing so is by being tax efficient. Tax efficiency means taking advantage of tax-beneficial accounts, making transactions in a specific way to decrease tax liability, and maximizing contributions at certain times. By following a set tax efficiency strategy, taxpayers can minimize what they pay to the IRS.