Why Is Tax Efficient Investment Important?
Consideration of tax efficient investment is important because it will reduce your tax burden.
In essence, tax Efficiency is about saving taxes by investing strategically among tax-advantaged accounts and taxable accounts. The bottom line of tax efficient investing is reducing your tax burden by either saving on taxes or defer paying taxes.
There are a few strategies you can use to reduce your tax burden.
- Maximize contributions tax advantage accounts
- Choose tax-efficient investments
- Reduce capital gains tax by holding your investment longer
- Place least efficient investment in tax advantaged account
- Tax loss harvesting
- Other tax efficient investments
Let’s look at each one in detail so you can decide what fits best with your financial plan.
Maximize Tax Advantaged Accounts
The first step in tax efficient investment is to maximize your tax advantage accounts such as 401(k) (employee sponsored retirement account) and IRA (individual, self-directed retirement account). In a tax advantaged account you reduce your tax burden by deferring taxes and making your investment grow faster. In 2020, you can contribute $19,500 in a 401(k) ($26,000 for 50 and over) and $6,000 to an IRA ($7,500 for 50 and above).
Choose Tax-Efficient Investments
After maximizing your contribution to tax advantaged accounts, let’s review investment strategies in a taxable account. Consider investing your savings into tax-efficient investments such as broad based stock index funds, tax-exempt bond funds, and/or tax-managed stock funds.
Tax-exempt bonds or municipal bonds issued by state, city and local governments are tax efficient as you do not pay federal taxes on the income from municipal bonds.
The tax-managed stock funds minimize taxes by avoiding investing in stocks that pay dividends and hold stocks more than 1 year or longer.
Index funds track the underlying index so they replicate the holding of the index and do not buy and sell stocks as frequently as actively managed funds, thus minimizing capital gains. In addition, the majority of dividends from US large stock equity index funds are considered “qualified” dividends.
So why is getting a more qualified dividend important? Because it will save you money by paying less in taxes as compared to ordinary dividends.
Let’s compare tax treatment of qualified dividend vs. ordinary dividend.
Tax Treatment of Dividends
The ordinary dividend and interest are taxed at the marginal federal income tax level. While the qualified dividends are taxed at long-term capital gains level.
According to IRS.gov,the maximum long-term capital gains tax rate in 2020 is 23.8% (20% plus 3.8% if your income is above a certain threshold) while the maximum federal income tax level is 37%. For example, if you are married filing jointly and making $175,000 dollars, you will pay 15% in capital gains tax on qualified investment income while your ordinary dividend and interest will be taxed at your federal income tax level of 24%.
The higher your federal income tax rate, the more you save in taxes from qualified investment income. For example, a couple making $450,000 and filing married jointly will pay a maximum of 18.5% in capital gains on qualified investment income while their ordinary dividend and interest will be taxed at the federal income tax level of 35%, almost doubled!
Tax Efficient Investment Examples
Here are some examples of tax efficient mutual funds / ETFs with % of qualified dividends (2019) from Vanguard.
- Total Stock Market Index Fund: 93.79%
- S&P 500 Index Funds: 100.00%
- Small-Cap Index Fund: 69.37%
Reduce Capital Gains Tax
Capital gain is when you sell investment at higher price than the purchase price; while capital loss is when you sell investment at lower price than the purchase price. You will have to pay either short-term or long-term capital gains tax on your profit depending on your holding period. In general if you hold your investment more than one year before you sell it, your capital gain is considered long-term. Long-term capital tax rate is much lower than the short-term capital gain rate, specifically, if you are in a high federal tax bracket.
According to IRS.gov,the maximum long-term capital gains tax rate in 2020 is 23.8% (20% plus 3.8% net investment income tax (NIIT), if your income is above a certain threshold); while the short-term capital gains tax rate could be potentially 40.8% (37% highest federal tax rate plus 3.8% NIIT). So it is definitely beneficial to hold your investment for a longer period; however, you should review risk and return of your investment.
Tax Advantaged Account Investment Choice
Actively managed stock funds, Real Estate Investment Trust (REIT) funds, and high-yield corporate bonds are some of the examples of the least tax efficient investment. Although I discourage investing in actively managed stock funds, if you decide to invest in one, I would place it in a tax advantaged account. If REIT is one of your asset classes, it is also best to place it in a tax-advantaged account. Because the majority of income from REIT is taxed at the ordinary income tax level. For example, Vanguard Real Estate Index Fund qualified dividend income is 3.59%, meaning more than 95% of income from this REIT fund will be taxed at your federal income tax level if you keep REIT in your taxable account.
Tax Loss Harvesting
You can use tax loss harvesting to reduce your tax burden. But you can only use this strategy in a taxable account. For example, if the price of any of your investments is lower than what you paid for, you can sell the investment at a loss and invest in a “similar” investment type to keep your exposure to the asset class. There are certain IRS rules you have to follow to employ this strategy. Then you can use the loss to offset realized investment gains and up to $3,000 in taxable income. By “harvesting the loss” you save on taxes. This is a huge topic which we will cover in a future post.
Other Tax Efficient Investment Options
College 529 Plans
If you have kids, you can start saving for his/her education using a 529 savings plan. Although you fund your 529 plan with after tax money, it provides tax-deferred growth. In addition, if you use the investment for qualified expenses, the withdrawal from the plan is federal income tax-free.
Health Savings Account (HSA)
Health Savings Account (HSA) is another tax-efficient investment vehicle with triple tax benefits.
- Ability to deduct contribution from your taxable income
- Tax-deferred growth
- Tax-Free withdrawal for qualified medical expenses
Summary
Tax efficient investing will minimize your tax burden. Consider placing most tax efficient investments such as stock index funds and tax-exempt bond funds in your taxable account. While placing least tax efficient investments such as REIT funds in your tax advantaged account. Although taxes are an important consideration when choosing your investments, you should not let it drive your investment decision. As many in the financial planning community would say “don’t let the tax tail wag the dog”.
Have you considered tax efficiency when making investment choices?