By Chris Risenmay, CFP®
March 2017
When it comes to investing, it’s not just what you earn, but what you keep after taxes that matters. Between federal income and capital gains taxes, the alternative minimum tax, and state and local taxes, your earnings can take quite a hit. Tax-efficient investing is crucial in building assets, especially if you are in the higher tax brackets.
Tax efficiency is basically an attempt to minimize tax liability. The more taxes you have to pay on an investment, the more tax-inefficient it is said to be. The more you are able to reduce your tax liability, the more tax-efficient the investment.
Different kinds of investment accounts receive different tax treatment. The three kinds of accounts available are taxable, tax-deferred, and tax-exempt. Where you put various kinds of investments can have a huge bearing on your tax liability, so it is important to understand the tax treatment of each account.
When held in a taxable account, investors pay taxes on income in the year it was received. Some taxable accounts are individual and joint investment accounts, money market mutual funds, and bank accounts.
Tax-deferred accounts allow an investor to put off paying taxes on the investment income until a later date. Most retirement accounts are tax-deferred, such as 401(k)s, 403(b)s, and IRAs. Income in these accounts is not taxed, but the withdrawals are.
Tax-exempt means that taxes are never paid on the investment income earned in the account. Canada’s Tax-Free Savings Account and American Health Savings Accounts (HSAs) are both tax-exempt. While an HSA is not designed as an investment account, many people use it as such to save towards retirement healthcare costs because of its favorable tax treatment.
Because different kinds of investment accounts have different levels of tax efficiency, the first step in minimizing your tax liability is managing where you hold your investments. You should hold your least tax-efficient investments in tax-advantaged accounts and your most tax-efficient investments in taxable accounts.
While this might make you think it would make more sense to only hold tax-advantaged accounts, there are a few more things to consider. First of all, it may not be possible to hold all of your investments in tax-advantaged accounts because of IRS contribution and income limitations. Secondly, account diversification offers you more options during the distribution phase in retirement. If you hold investments in both kinds of accounts, you can manage your tax exposure and control your tax bracket through strategic withdrawals. Finally, having different kinds of accounts can make for more efficient charitable giving and estate planning, since the rules vary among accounts.
Generally, an investment is less tax-efficient the more it relies on investment income as opposed to a change in its price to generate a return. As mentioned above, it is important to understand the tax-efficiency of your investment in order to put it in the most appropriate kind of account, thus limiting your tax liability.
Junk bonds are one of the least tax-efficient investments because their high yields are taxed at the ordinary income rate. Both straight-preferred stocks and convertible preferred stocks are also highly tax-inefficient because they are also taxed at ordinary income rates.[1] Actively managed funds that generate significant short-term gains are tax-inefficient, and should, therefore, be held in tax-advantaged accounts.
Convertible bonds and investment-grade corporate bonds are considered tax-efficient when held in tax-advantaged accounts because of their low yields. One of the most tax-efficient investments is common stock if held over a year so as to be taxed at the lower capital gains rates.[2] Tax-managed stock funds, index funds, and exchange-traded funds (ETFs) are all tax-efficient because of their low turnover. Municipal bonds are the most tax-efficient investment because they are exempt from federal taxes. However, they usually pay lower yields than investment-grade bonds, representing an opportunity cost for investors.
If you intend to pass on any assets to heirs or charities, it is important to understand the tax implications of different kinds of holdings. Appreciated securities held in taxable accounts are a good option for charitable giving. You get to deduct the full fair market value of the securities and pay no capital gains. The charity benefits too, by getting a larger donation than if you were to liquidate and pay capital gains.
When leaving stocks to your heirs, it is better for them to be in taxable accounts, because they will receive a step-up in cost basis upon your passing. If left in tax-deferred accounts, distributions are taxed as ordinary income. Roth IRAs are excellent for estate planning because your heirs can continue to let them grow and never pay income tax on the distributions.[3]
As you see, there is a lot to consider in tax-efficient investing. Types of accounts, types of investments, final purposes of the investments, they all come into play. There is no need to feel overwhelmed though. We have a team of experienced financial professionals ready to help you. Call our office today at 866.888.6563 and we can sit down for a complimentary consultation to discuss your investments and how best to limit your tax liability.
About Cypress Wealth Services
Cypress Wealth Services, an independent RIA firm providing financial planning and investment management to high net worth individuals, families, business owners, and institutions. CWS is comprised of professionals with diverse backgrounds and extensive experience and qualifications. CWS is uniquely qualified to serve a broad range of client needs. Their experience and expertise act as a foundation for their client service process, The Second Growth, which focuses on efficiently protecting, growing, and transferring to their loved ones the wealth and legacy a person has already built. With offices in Palm Desert, and Anchorage, the firm serves clients across the country. Learn more by visiting www.CypressWS.com.
