An individual or business pays the least amount of taxes required by law. A financial decision is said to be tax-efficient if the tax outcome is lower than another alternative financial structure.
What You Need To Know
- Individuals and businesses should pay the least amount of taxes necessary to stay in compliance with the law.
- Individual Retirement Accounts (IRAs) and 401(k) plans are tax-deferred accounts that produce income.
- Compared to other mutual funds, tax-efficient funds are taxed at a lower rate.
- Tax-exempt municipal bonds are available to bond investors.
- Investing in an irrevocable trust can also reduce estate taxes.
The concept of tax efficiency
Investments in the public markets can be structured in a tax-efficient manner to receive the least amount of taxation.
Tax-deferred investments such as Individual Retirement Accounts (IRAs), 401(k) plans, and annuities allow taxpayers to earn income while tax-deferred. As a result of the investments, any dividends or capital gains earned will be automatically reinvested, which will continue to grow tax-deferred until withdrawal.
Traditional retirement accounts save investors money on taxes by reducing their current year’s income by the amount they place into them. The investor gets an upfront tax break when he or she deposits the funds, but he or she is taxed on the distribution once they retire. Conversely, Roth IRAs do not offer the same tax break from depositing the funds. However, Roth IRAs allow investors to withdraw funds free of tax in retirement.
2020 Retirement Account Changes
Congress passed the SECURE Act in 2019, changing some of the retirement account rules. Here are a few of the changes that went into effect in 2020.
401(k) annuities can now be portable if you have them in your retirement plan. Thus, if you leave your job and find a new one, you can roll over your annuity into your new company’s plan. In addition, the new law reduced the possibility of account holders suing annuity providers if they fail to make payments, thereby reducing some of the legal liabilities that annuity providers faced previously.
You may also be affected by the new ruling if you use tax-planning strategies that include distributing money to beneficiaries. Under the SECURE Act, non-spousal beneficiaries of inherited IRAs were permitted to take only the required minimum distributions (RMDs). In 2020, beneficiaries of non-spousal IRAs will have to withdraw all funds within ten years after the owner’s death. Since the Act removed the age limit for IRA contributions, investors of any age can contribute to a traditional IRA and receive a tax deduction.
Recent changes have also been made to required minimum distributions. Originally, RMDs were not required until 70 1/2. The age limit for RMDs was increased to 72 as part of the SECURE Act. In May 2023, the RMD age was increased again to 73 as part of the SECURE 2.0 Act.
Tax-Efficient Mutual Fund
Another way to reduce tax liability is to invest in a tax-efficient mutual fund, especially if you don’t have a tax-deferred or tax-free account. Mutual funds that are tax-efficient are taxed at a lower rate than their peers. The dividends and capital gains generated by these funds are generally lower than those generated by the average mutual fund. Mutual funds that generate little to no interest income or dividends include small-cap stock funds and passively managed funds, such as index funds and exchange-traded funds (ETFs).
Gains and Losses on Long-Term Capital Assets
When a taxpayer holds stocks for more than a year, he or she will pay the longer-term capital gains rate, rather than the ordinary income tax rate that applies to investments held for less than a year. A taxable capital gain can also be offset with a current or past capital loss to reduce taxes.
Bonds exempt from taxation
In addition to being exempt from federal taxes, municipal bonds are also exempt from state taxes if they are issued in the investor’s residence state.
The irrevocable trust
In order to maximize estate tax efficiency, irrevocable trusts are useful for estate planning purposes. Since the trust cannot be revoked and the resources cannot be retrieved, the individual surrenders ownership of the assets when it is held in it. The property owner is, therefore, removing assets from their taxable estate when funding an irrevocable trust. A number of irrevocable trusts are used for estate tax efficiency purposes, including generation-skipping trusts, qualified personal residence trusts, grantor retained annuity trusts (GRATs), charitable lead trusts, and charitable remainder trusts. The assets held in a revocable trust, however, are still included in the estate for tax purposes, making it not tax-efficient.
It is by no means an exhaustive list of tax-saving strategies. Financial professionals can help individuals and businesses determine which strategies are most effective for reducing their tax bills.
As a result of the potential savings they can make, investors in high tax brackets are more likely to invest in tax-efficient investments. If you don’t know much about the different types of tax-efficient investments available, picking the right one can be challenging. To determine if there is a way to make investments more tax efficient, you may want to speak with a financial professional.
Tax Efficiency: How Do You Calculate It?
Using the net return of the return, subtract the amount of tax paid to calculate tax efficiency. A taxpayer’s tax efficiency is determined by the proportion of net return divided by gross return. The higher the percentage, the more income an individual retains.
Are there any ways I can increase my tax efficiency?
By using appropriate investment vehicles, you can become more tax efficient. You can defer or avoid taxes by contributing to your employer’s 401(k), leveraging an individual retirement account, or exploring other strategies. Gifting appreciating assets rather than selling and recognizing a capital gain can also increase tax efficiency.
How Ethical Is Tax Efficiency?
Especially when high net worth individuals are capturing tax efficiency, some people believe it is unfair. For example, if a billionaire pays a lower effective tax rate than a poor person, he is technically not doing anything illegal as long as he follows the IRS‘s rules. Therefore, some may argue that tax efficiency is an unethical way of finding tax loopholes to maneuver out of liability. Regardless, tax efficiency isn’t illegal in any way.
One way in which individual taxpayers can maximize their money is by being tax efficient. By taking advantage of tax-beneficial accounts, making transactions in a specific way to reduce tax liabilities, and making contributions at certain times, taxpayers can minimize their tax liabilities. Taxpayers can minimize their tax liability by following a set tax efficiency strategy.