What is Tax Efficient Investing and How Can I Take Advantage of It
Tax efficient investing means carefully choosing certain investments and determining which accounts to hold them in to reduce to reduce your overall tax bill. Saving money on taxes allows you to make larger investments and keep more of the returns. In the long run, due to the power of compounding, this can have a dramatic impact on your overall net worth.
When investing, there are things that you can control and things that you cannot control. One area where you do have control over is your taxes. One way the wealthy became that way was by taking advantage of tax laws.
The impact of tax laws can vary widely based on your unique situation, so it is best to meet with a qualified accountant to help you establish a plan as soon as possible.
- Take advantage of opportunities to reduce your tax liability to maximize your eventual net worth
- Certain types of investments are more tax efficient than others
- Certain types of investment holding accounts are more tax efficient than others
- Always hold your least tax efficient investments in your more tax efficient accounts
Certain Investments are More Tax Efficient Than Others
Which investments you hold and how you hold them can have a tremendous impact on your long term returns. The power of compounding can turn small differences now into large differences when you are older. There are essentially two concepts to keep in mind here, and they are somewhat related.
- Some investments are more tax efficient than others
- Some accounts are more tax friendly than others
Your goal should be to hold your least efficient investments in your most tax efficient accounts. As an example, you can do short term trading inside of a Roth IRA and totally avoid short term capital gains tax!
What Makes an Investment Tax Efficient?
Now that you know that some investments are more tax efficient than others let us look at what makes an investment tax efficient. Investments that generate capital gains and dividends during the year will be generating a tax liability for you in addition to the income. The more income that the investment generates the higher the tax liability.
Alternatively, growth investments will not generate any income until you sell them. This can allow you flexibility for when to earn the income, thus giving you control over when you pay the tax and how much tax you end up paying. How long you hold an investment matters. In general, if you hold an investment for over a year you get a reduced tax bill when you sell it.
Let’s take a closer look at how investments generate income and as a result income tax.
How Do Investments Generate Tax Liability
Investments can generate taxable income in several ways. In general, if you sell an investment for more than you paid for it this is called a capital gain. You will need to pay tax on the capital gain. Also, any cash flows generated from the investment while you own it are taxable income.
Types of Investment Income
- Capital Gains – A capital gain is income you generate when you sell an investment for more than you paid for it. It is defined as sale price – purchase price = capital gain. Real estate and certain other assets can be more difficult calculate because deprecation of the original purchase price is allowed. Investments held for more than 1 year before being sold are taxed as long-term gains and have a top federal rate of 23.8% (versus 40.8% for short-term). This means you should always hold investments you intend to sell within a year in a tax advantaged account.
- Dividends, Interest and Rent – These are cash payments that are made you for owning the asset. Stocks can pay dividends, bonds can pay interest, and real estate can pay you rent. Dividends that are paid on a stock are taxed at the same rate that the capital gains would be on that stock. This means that for the first year, you would be responsible for short term rate on the dividends.
This is an important concept for stocks. Growth stocks pay very little dividends but have a high appreciation rate. Dividend stocks have a more stable rate of appreciation but pay frequent dividends. This means dividend stocks are more appropriately held in tax advantaged accounts and growth stocks that you intend to hold for more than a year can be held in a taxable account.
Examples of Investments
|Actively Managed Mutual Funds||Low|
|Securities Held Short Term(< 1 year)||Low|
What are Tax Efficient Accounts?
Uncle Sam gives you multiple options to hold investments in accounts where you won’t generate any tax liability at all. The most commons ones are IRAs, 401Ks, Health Savings Accounts and Roth IRAs. Here is a complete list of the tax advantaged accounts available to you.
Only use a taxable account once you have maxed out your other areas of savings. Only highly efficient investments should be held in a taxable account. You will have to pay tax on your gains and dividends here, so you should hold your most efficient investments here.
Should I Hold Tax Inefficient Investments at All?
You only have so much money to invest and you should be concerned with the opportunity cost of your investment choices. This may make you wonder why you would even invest in a tax inefficient choice to begin with.
You should not rule out tax inefficient investments, you should just be careful where you hold them. Many tax inefficient investments can have a good risk adjusted return provided you can mitigate the tax liability inherent with holding them. Ultimately this will help you with diversification of your investments.
Take Advantage of as Many Tax Strategies as Possible
A rational person should seek to pay the least amount of tax and generate the highest returns on their investments. You should take advantage of every available way of avoiding taxes that you can. The implications in any single tax year may not be dramatic, but over the course of your lifetime the power of compounding can turn that reduced tax bill into a fortune.
Tax efficiency should not be your primary concern when choosing an investment, but it should be considered. Don’t eliminate an investment from consideration just because it has a low tax efficiency, but do hold it in a tax efficient account. Pay attention to the period of time you expect to hold an investment. Short term capital gains tax can be avoided completely if you hold the stock in a Roth IRA for example.
Ultimately reducing your tax burden will allow you to keep more money invested and due to the power of compounding it can have a dramatic impact on your long term returns.