Dec 20, 2023 By Triston Martin
If a person or company can minimize their tax liability, they are said to be tax efficient. If the net tax consequence of one financial choice is less than that of another economic structure that yields the same result, then that choice is tax-efficient.
While investment choice and asset allocation are the most critical factors affecting returns, the Schwab Center for Financial Research study revealed that limiting the amount of taxes you pay also has a substantial influence. This is the case for two reasons. One is that all that tax money is gone forever. The other is the foregone opportunity cost of continuing to invest the money.
To a greater extent than before taxes, you should focus on your net profit. Remember that you'll be spending those after-tax funds both now and in retirement. Tax-efficient investment is essential to optimize your profits and keep more of your money.
Investing in a tax-efficient manner requires careful consideration of the investments themselves and the accounts in which they are held. When it comes to saving and investing, you have two primary options:
Among the many types of taxable accounts is a brokerage account. Though they don't provide any tax breaks as traditional retirement funds or 401(k)s do, these accounts are more flexible and have fewer rules to follow.
For-profits on assets held for more than a year, account holders will be subject to the lower long-term capital gains rate. Gains on investments held for less than a year are considered short-term and are taxed at the same rate as regular income.
Depending on the kind of account, taxes can be postponed or avoided using tax advantages. You may now save money on your taxes by contributing to a tax-deferred account, such as a standard IRA or a 401(k) plan. Contributions to these programs may qualify for a tax deduction, meaning you may save money immediately.
The rules for tax-free accounts, such as Roth IRAs and Roth 401(k)s, are different. Unlike typical IRAs and 401(k)s, contributions to such plans are made with after-tax funds and do not qualify for an immediate tax deduction.
The amount you may put into tax-deferred accounts like IRAs and 401(k)s each year is capped. You may put $6,000 years into your IRA in 2021 and 2022, or $7,000 if you're 50 or older (thanks to a $1,000 catch-up contribution). The maximum 401(k) contribution for 2020 is $19,500, while the maximum for 2021 is $26,000 if you are 50 or older. For 2022, the maximum allowed contribution is $40,500, or $47,000 with the catch-up contribution. In 2021 and '22, the maximum amount that an employee and employer may put together is $58,000 and $61,000.
Most investors know that there may be tax consequences when selling investments. However, whether or not you sell your investment, you may still be responsible for paying any capital gains or dividends that have accrued. Some assets are more tax-efficient just by their very nature.
When it comes to stock funds, for instance, tax-managed funds and exchange-traded funds are sometimes more advantageous since they produce fewer capital gains. Capital gains distributions may be more common in actively managed funds because of the greater frequency with which securities are purchased and sold.
With the enactment of the SECURE Act in 2019, the United States Congress modified the regulations governing retirement funds. The new rule makes it possible to take an annuity out of a retirement plan and use it elsewhere.
By limiting account holders' recourse to legal action against annuity issuers in the event of a failure to make annuity payments, the new law reduces the legal risks that issuers previously faced. The recent judgment might affect those whose tax plans involve giving money to loved ones.
The stretch provision, which had once enabled non-spousal beneficiaries of an inherited IRA to withdraw more than the minimum necessary, was repealed by the SECURE Act. As of 2020, non-spousal beneficiaries of an IRA will be required to remove the whole balance within ten years after the owner's death.
Investing in a tax-efficient mutual fund may be an option for taxpayers without access to a tax-deferred or tax-free account. If you're looking for a mutual fund, you might consider investing in one that pays fewer taxes than its competitors.
Dividend and capital gain yields from these products are often lower than regular mutual funds. Mutual funds that hold small-cap stocks or are passively managed, like index funds or exchange-traded funds, usually pay very little interest or dividends.