Tax-Efficient Investing & Why it Is Important
Taxes are not just something we must live with. They are key to our growth as a nation. But while we are happy to pay taxes, it is worth remembering that not taking advantage of strategies to reduce your tax burden is not good for your financial health.
When it comes to investments, taxes can make up the biggest expense, taking a significant portion of your returns.
In the long run, these deductions build up, costing you a lot of money that you could have kept had you taken advantage of tax-efficient investing.
What Is Tax-Efficient Investing?
Tax-efficient investing means taking measures that minimize your tax burden on investments. There are several ways to do that.
For example, strategically choosing asset classes and the accounts that hold them can help reduce your tax bill.
Known strategies for maximizing tax efficiency involve holding investments that lose less to taxes in taxable accounts and those that lose more in tax-advantaged accounts.
Types of Tax-Efficient Investments
Understanding which accounts to hold your investments is crucial. But even more important is knowing which investments are tax-favorable by nature. Here are a number of tax-efficient investments to consider:
Index Funds
Index funds are more tax-efficient than active mutual funds, which trade in and out of positions, triggering high capital gains and more taxes. As a passively managed alternative, index funds hold their positions, offering lower turnover but generating less taxable capital gains.
Exchange-Traded Funds
ETFs are bundled investments that also trade on exchanges. They are not like mutual funds but are similar to index mutual funds since both are passively managed. In addition, ETFs are designed in a way that generates less capital gains, making them more tax-efficient.
Municipal Bonds
Municipal bonds are an example of highly tax-efficient bonds because they don’t incur federal income tax. Also, these bonds are not subject to state or local taxes in the state where they were issued. Since ‘munis’ are already tax-efficient on multiple levels, it is best to hold them in taxable accounts.
Treasury Bonds
While munis are sometimes taxable by states, the interest from treasury bonds has a clear tax advantage as they are not subject to state and local taxes. These securities, which include treasury bills, treasury notes, and treasury bonds, are, however, subject to federal taxes.
Series I Bonds
Series I Bonds or I bonds are a class of savings bonds issued by the US treasury that offer investors unique benefits. These bonds are among the most low-risk investments, earning at a fixed interest rate throughout their duration.
Another advantage is the protection against inflation, as the rate is adjusted every six months. Besides these benefits, interest earned from I bonds is exempt from state and local taxes.
Other Investment Avenues
Aside from common assets like those we have mentioned, there are other asset classes that have tax advantages, such as Real Estate and Permanent Life Insurance.
With real estate investing, you can capitalize on interest deductions and write-offs, among other benefits.
Permanent life insurance or cash value insurance offers tax-deferred gains. Usually, beneficiaries receive proceeds free of income tax. This page provides more information on how to benefit from these two asset classes.
Why Is Tax-Efficient Investing Important?
While everyone should pay their share of taxes, one must remember that taxes can eat away a significant portion of investment returns over time. By using tax-efficient strategies, you get to lower the effect of taxes on your investment gains, keeping more of your earnings.
Maximizing tax efficiency is also crucial to the growth of your portfolio. When you keep more of your earnings, you can accelerate the growth of your wealth faster by reinvesting your returns. The advantage of compounding these returns is that it’s easier to achieve your financial goals.
Ultimately, tax efficiency allows you to optimize investment returns and preserve your wealth.
Bottom Line
Spending less on taxes is a legal privilege allowed under certain conditions. As you pay taxes, it’s important to consider these provisions and see how you can ease tax implications and benefit more from your investments.
When it comes to positioning your investments so they can be fully tax-efficient, you will need to weigh which investments, strategies, and accounts can lower your tax burden. Such an exercise may require the assistance of financial management professionals.
