In the investing world, tax efficiency refers to how well your investment portfolio takes advantage of legal ways to avoid or defer paying taxes on your returns. Tax-efficient investing sounds intimidating, but the basics are easier than you might think and important enough for every investor to learn.
Profits you earn from investments are taxed as capital gains. Prior to 2013*, long-term capital gains — anything held for more than one year — were taxed at 15 percent, while short-term capital gains — anything held for less than one year — were taxed at your ordinary income tax rate (28 percent, 35 percent, etc.)
*There are some changes coming this year that mostly affect investors with incomes over $200,000.
Your goal as a tax-efficient investor is to avoid paying short-term capital gains taxes and to postpone paying any capital gains taxes as long as you can. In addition, certain types of accounts (like IRAs) and investments (such as municipal bonds) allow you to defer paying taxes or avoid them altogether.
Here we’ll look at a couple easy ways to improve your investments’ tax efficiency.
Before diving in, we should note that your annual income plays a big role in whether many of these strategies will be beneficial, so it it’s a good idea to go over them with tax professional to see the true impact on your bottom line.
1. Look out for tax-inefficient mutual funds
If you’re investing in mutual funds, that should be your first stop in optimizing your investments for tax efficiency.
Although mutual funds offer plenty of benefits, they tend to be inefficient when it comes to passing on the tax consequences of their trades to individual investors. Mutual fund dividend payments made by a mutual fund — even if they are reinvested — will still need to be claimed as ordinary income, so a high dividend fund implies higher taxes.
Turnover is another major contributor to a mutual fund’s tax efficiency (or lack thereof). Turnover tells you how long the fund’s management holds onto stocks they buy. The higher the number, the more often the fund trades and the more trading costs are passed onto you. A tool like Morningstar’s free mutual fund information can easily give you a fund’s turnover rate.
To improve your tax efficiency, consider replacing high-turnover mutual funds with an equivalent exchange-traded fund (ETF).
2. Reevaluate a Roth IRA vs. a traditional IRA
Next, you’ll want to look at how IRAs and Roth IRAs compare and ensure you’re using the right one.
With a traditional IRA, money is invested before taxes, thus deferring taxes until you withdraw at age 59 ½. With a Roth IRA you pay taxes upfront. allowing you to withdraw money tax-free in retirement.
If you earn a lot now but expect your income to drop substantially in retirement, the traditional IRA may be the better route for you. I’ve covered this subject in more detail earlier and you can go to Bankrate.com to play around with the numbers and see which option is best for you.
3. Consider tax-advantaged investments
Certain investments come with preferential tax treatments.
Municipal bonds, for example, are used for funding of public projects like roads and schools. As a result, they provide income that’s free of federal taxes (and, in some cases, state and local taxes, too).
Treasury bonds are another example of an investment that’s tax-free at the federal level. Treasuries yield lower amounts than fully-taxable equivalents like corporate bonds, but Treasuries actually net you more after taxes.
Let’s take a look at an example to help illustrate how this works. The equation used to determine a comparable taxed investment versus a tax-free one is:
- Taxed Comparable = Tax Free Comparable / (1-Tax Rate).
If an investor’s tax bracket is 35 percent, and he can invest his money tax-free at 5 percent, then the amount he needs to make from a taxable investment is:
- 7.7 percent [7.7 percent = 5 percent / (1-35 percent)].
Now, what happens if taxes are raised to 45 percent instead of 35 percent? In this case, the investor would need to make 9.1 percent in order to make the same amount of money as the tax-free one at 5 percent.
You don’t need to plan your entire portfolio around the potential tax consequences of being profitable, but you should remain cognizant of how each year will look. You don’t want to be in a situation where you have to sell investments that may be locked into long term strategies just to pay the taxes due. There’s no faster way to become disillusioned with investing. Just being aware of what you own can go a long way toward your financial success.
Do you have any additional tips or questions about making a tax-friendly investment?