What is tax efficiency?
Tax efficiency is when an individual or business pays the least tax required by law. A financial decision is said to be fiscally efficient if the tax result is lower than another financial structure that achieves the same objective.
Key points to remember
- Tax efficiency is when an individual or business pays the least tax required by law.
- A taxpayer can open tax-deferred income-generating accounts, such as an Individual Retirement Account (IRA) or a 401(k) plan.
- Tax-advantaged mutual funds are taxed at a lower rate than other mutual funds.
- A bond investor can opt for municipal bonds, which are exempt from federal taxes.
Understanding tax efficiency
Tax efficiency refers to structuring an investment so that it receives the least tax possible. There are several ways to achieve tax efficiency when investing in public markets.
A taxpayer may open an income-producing account in which investment income is tax-deferredlike a Individual Retirement Account (IRA), a 401(k) plan or annuity. Any dividends or capital gains earned on investments are automatically reinvested in the account, which continues to grow tax-free until withdrawals are made.
With a traditional retirement account, the investor obtains tax savings by reducing current year income by the amount of funds placed in the account. In other words, there is an initial tax benefit, but when the funds are withdrawn in retirement, the investor must pay taxes on the distribution. On the other hand, Roth IRA do not provide the initial tax relief of 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 US Congress. Below are some of these changes that will take effect in 2020.
If you have an annuity in your pension plan, the new decision allows the portability of the annuity. So if you leave your job to take up another job at another company, your 401(k) pension can be transferred into your new company’s plan. 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 annuity payments.
For those with tax planning strategies that include leaving money to beneficiaries, the new ruling may affect you as well. The SECURE Act removed the stretch provision, which allowed non-spousal beneficiaries to take only the minimum required distributions from an inherited IRA. Starting in 2020, non-spouse beneficiaries who inherit an IRA must withdraw all funds within ten years of 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 law has removed the age limit for IRA contributions. In addition, the required minimum distributions do not need to start before age 72, as opposed to 70½ previously. Therefore, it is important that investors consult with a financial professional to review the new changes to retirement accounts and determine if the changes affect your tax strategy.
Tax-efficient mutual fund
Invest in a tax-efficient mutual fund, especially for taxpayers who do not have a tax-deferred or tax-free account, is another way to reduce tax liability. A tax-advantaged mutual fund is taxed at a lower rate than other mutual funds. These funds typically generate lower rates of return through dividends or capital gains than the average mutual fund. Small cap equity funds and passively managed funds, such as index funds and exchange traded funds (ETFs) are good examples of mutual funds that generate little or no interest income or dividends.
Long-term capital gains and losses
A taxpayer can achieve tax efficiency by holding shares for more than one year, which will subject the investor to the most favorable regime long-term capital gains rate, rather than the ordinary income tax rate applied to investments held for less than one year. In addition, offsetting taxable capital gains against current or past capital losses may reduce the amount of investment profits that is taxed.
Tax exempt bonds
A bond investor can opt for municipal bonds more corporate bonds, since the former is exempt from taxes at the federal level. If the investor purchases a municipal bond issued in their state of residence, 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 tax efficiency on inheritances. When an individual holds assets in this type of trust, he gives up ownership incidents, as he cannot revoke the trust and take back the resources. Therefore, when an irrevocable trust is funded, the owner is effectively removing the assets from their taxable estate. Generation Skip Trusts, Qualified Personal Residence Trusts, annuity trusts retained by settlor (GRAT), charitable master trusts and charitable residual trusts are some of the irrevocable trusts used for estate tax efficiency purposes. On the other hand, a revocable trust is not tax-advantaged because the trust can be revoked and therefore the assets held in it are still part of the estate for tax purposes.
These tax efficiency strategies 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 higher tax brackets are often more interested in tax-efficient investments because their potential savings are greater. However, choosing the best tax-efficient investment can be a daunting task for those unfamiliar with 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 investing more tax efficient.
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