What Is Tax Efficiency?
Tax efficiency involves minimizing taxes legally owed by individuals or businesses. A financial choice is considered tax-efficient when it results in lower taxes compared to alternative structures achieving the same goal.
Key Takeaways:
- Tax efficiency aims to reduce taxes within legal boundaries.
- Consider income-producing accounts like IRAs or 401(k) plans for tax deferral.
- Tax-efficient mutual funds are taxed at lower rates.
- Opt for tax-exempt municipal bonds for federal tax savings.
- Irrevocable trusts can offer estate tax efficiency benefits.
Understanding Tax Efficiency
Tax efficiency refers to structuring investments to minimize taxation. Various strategies exist to achieve tax efficiency, particularly in public markets.
Taxpayers can open income-producing accounts, such as IRAs or 401(k) plans, where investment income is tax-deferred. Withdrawals are taxable upon distribution, offering tax benefits. Roth IRAs provide tax-free withdrawals in retirement.
Changes to Retirement Accounts Starting in 2020
The SECURE Act of 2019 introduced changes to retirement account rules effective in 2020. Annuities in 401(k) plans can now be portable, and the stretch provision for non-spousal IRA beneficiaries was eliminated.
Additionally, RMDs now begin at age 72, increasing to 73 in 2023. The Act allows any-age contributions to traditional IRAs, removed the stretch provision, and impacted tax-planning strategies for beneficiaries.
Tax-Efficient Mutual Fund
Tax-efficient mutual funds are ideal for reducing tax liability, especially for those lacking tax-deferred accounts. These funds are taxed at lower rates, with examples including small-cap stock funds and passively-managed funds like index funds and ETFs.
Long-Term Capital Gains and Losses
Holding stocks for over a year to benefit from long-term capital gains rates is a tax-efficient strategy. Offsetting taxable gains with losses can also reduce taxable profit.
Tax-Exempt Bonds
Opt for municipal bonds over corporates for federal tax exemptions. State-resident issued bonds may also offer state tax exemptions on coupon payments.
Irrevocable Trust
Irrevocable trusts assist in estate tax efficiency by transferring assets out of the taxable estate. Types like generation-skipping trusts and charitable trusts are common for this purpose.
Tax efficiency strategies extend beyond this list, requiring advice from financial professionals for tailored solutions.
High tax bracket investors benefit significantly from tax-efficient investing, but choosing the right strategy may be complex without expertise.
How Do You Calculate Tax Efficiency?
You can calculate tax efficiency by subtracting taxes paid from returns to find the net return ratio. Higher ratios indicate greater tax efficiency in retaining income.
How Can I Increase My Tax Efficiency?
Maximize tax efficiency by utilizing suitable investment vehicles like 401(k)s or IRAs. Consider gifting appreciating assets instead of selling to avoid capital gains taxes.
Is Tax Efficiency Ethical?
While some question the fairness of tax efficiency, it remains legal within IRS guidelines. Ethical concerns arise when high net worth individuals benefit greatly from tax optimization.
The Bottom Line
Adopting tax-efficient strategies, such as leveraging tax-beneficial accounts and contributions, helps individuals minimize IRS payments and optimize wealth management.