How Tax Efficient Are Your Investments?

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by Advice Chaser
by Advice Chaser

Now that we’ve discussed measurements of risk and of performance, it’s time to talk about tax efficiency. Getting the best returns for the risk you take is important, but what if all those increased gains are lost to taxation? While all income is taxable at some point, there can be a vast difference in the tax you pay depending on the investment decisions you made.

That said, the easiest way to pay no taxes is never to earn any money. Any time you make a profit, there will be some amount of tax to pay, but you should still come out ahead. A good tax efficient investment strategy seeks to balance profits and tax liability.

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Factors Affecting Tax Efficiency

The United States tax code is around a million words long, or as long as a ten-volume set of encyclopedias—and that doesn’t even account for state and local taxes! Navigating these labyrinthine pathways efficiently is many people’s entire life’s work. As tax law changes, the most efficient strategy for a situation might change as well.

But a few factors tend to remain influential. First, short-term gains are taxed more than long-term gains. If you’ve held an investment for under a year, you pay tax on it equivalent to your usual income tax rate, which depends on your tax bracket. But if you’ve held it for more than a year, you pay tax at the lower capital gains tax rate.

Next, remember that tax only applies to gains you’ve realized. That means you owe nothing on an asset that has appreciated until you sell it. Assets you hold a long time tend to be more tax efficient than assets that are actively traded. Every time you buy and sell assets, you create more taxable income.

Third, keep in mind non-taxable or tax-privileged accounts. If you keep most of your investments in a retirement account, you will pay less in tax. Traditional 401(k)s and IRAs are taxed only when you withdraw the money, while Roth accounts are taxed before you put the money in. But in either case, there is no tax while the money accumulates in the account. That makes these accounts ideal for investments which otherwise would generate large capital gains.

Beyond this, there are endless factors. Some investments, like municipal bonds, are tax-exempt, and others, like opportunity zone investments, come with various tax benefits.

Measuring Tax Efficiency

Given the large differences between different investments’ tax efficiency, how can you compare one investment with another? Is it better to buy one with large gains and a high tax impact, or a more modest investment that won’t affect your tax bill? There are two main measurements, tax-adjusted returns and tax efficiency ratio.

Tax-Adjusted Returns

This is simply the total amount, after taxes, you take home. Some measurements don’t take into account state and local taxes, so for the full picture, you need to factor those in as well.

Tax Efficiency Ratio

The tax efficiency ratio is a measurement of what percent of the total assets are lost to taxes. Experts derive it by dividing something’s tax-adjusted earnings by its total earnings. For instance, if a mutual fund earned you $100 before taxes, and $90 after taxes, its tax efficiency is 90%. You can make the same calculation with your whole portfolio. But this measurement is especially favored for mutual funds, since the way a fund is managed can make a big difference in its tax efficiency.

“Don’t Let the Tax Tail Wag the Investment Dog”

This old adage reminds us that taxation is just one part of your total investment picture. What good would it do to avoid paying any taxes if you didn’t make any money? The goal should be to maximize your gains while doing so as tax efficiently as you can. Uncle Sam will take his piece of the pie, but if it’s a big pie, it shouldn’t hurt too much.

Depending on your tax bracket, tax efficiency may have more or less importance to you. Investors in a lower tax bracket won’t pay as much even on short-term gains. So talk to your advisor about the priority you place on tax efficiency. They should be able to direct you to strategies that work for your situation.

Your Biggest Ally

As you try to maximize profits and minimize tax impact, you’ll never have a better ally than your financial advisor. While an accountant can help prepare your tax return in the most beneficial way, an advisor can help you make decisions throughout the year that will improve your situation at tax time. To find an advisor skilled in tax efficiency strategies, contact us today. Every advisor on our list is qualified and ethical, and we can match you with the right person for your situation.

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