Reasons Why You Cannot Afford to Ignore Tax-Efficient Investing
Taxes have always been a sore component of any savings or investment plans. High taxes can erode your earnings, and lead to disappointments at the time of maturity. Tax also plays a crucial role in your decision to invest or save in a particular investment tool. In fact, taxes and earnings go hand in hand, which is why financial experts recommend selecting an investment based on its taxability rules and not just returns.
There are many types of taxes that you pay to the government for different kinds of earnings. These include estate tax, inheritance tax, income tax, short term and long term capital gains tax, etc. Such taxes can alter your earnings and the returns from your investments to a great extent. As a result, adopting strategies that can reduce or eliminate your tax liability is an essential part of a financial plan.
While planning for your future, it may also be advised to add tax planning to your list of things to do. And you can start by investing in some tax efficient options. You can also reach out to a professional financial advisor to understand more about tax efficient investing and how to incorporate it into your financial plan.
Read on to know more about the importance of tax efficient investing in your financial plan.
What is tax efficient investing?
As stated above, taxes can reduce the income from your investments and sometimes render them useless in the face of inflation. As a way to counter this, tax efficient investing aims at instruments that offer some tax relief. Tax deferred or tax exempt accounts can reduce the outflow of your money, otherwise spent on taxes, and increase your overall earnings. Some common types of tax efficient accounts include:
- A traditional 401(k) account
- A traditional IRA (Individual Retirement Account)
- A Roth 401(k) account
- A Roth IRA
Some common tax efficient investments include
- Exchange traded funds (ETFs)
- Treasury bonds
- Municipal bonds
Tax efficient methods are crucial for all investors. Here are some reasons why you cannot afford to ignore tax-efficient investing:
1. Tax-efficient investing lowers the effect of taxes and boosts your overall returns:
Investors often get enamored by the rate of return on their investments and savings accounts. However, it is only at the time of maturity that they realize that a significant part of these returns is paid up in taxes. These taxes are mandatory and are deducted from your earnings. They not only lower your net worth but also make it harder to retain the value of your money with a rising rate of inflation. But tax efficient investing can lower the negative effect of taxes on your returns. It can help you understand your tax liability from the very beginning and determine the best course of action to follow for a financially stable future.The best example to understand tax efficient investing can be to consider the difference between a traditional IRA and a Roth IRA. If you pick a Roth IRA to save for retirement, you will contribute your after-tax dollars so that your money grows tax-free for several years. At the time of maturity at the age of 59.5, when you withdraw from the account, your money will be tax-free without any penalties. On the other hand, if you chose a traditional IRA, your contributions to the account will grow tax-deferred. And when you make withdrawals after the age of 59.5, you will be taxed as per your current gross income for the concerned year.
People who see a higher income in retirement, generally opt for a Roth IRA as it helps them save on taxes. And people who have a higher income in the present tend to invest in a traditional IRA as their tax outflow reduces in retirement when they fall into a lower tax slab.
2. Tax-efficient investing helps to balance out your portfolio to offer high returns:
Investing in a combination of high yielding investments and tax efficient accounts balances out your portfolio’s risk and reward components. For instance, short term capital gains tax is a lot more as compared to long term capital gains tax. Similarly, a traditional IRA withdrawal would be added to your taxable income, but a qualified withdrawal from a Roth IRA would not be taxed. In addition to this, even though most brokerage accounts like mutual funds increase your tax liabilities, exchange traded funds can lower them. None of these options can be categorized as better than the other. However, a right balance of tax efficient options on your portfolio with enough tax friendly choices along with high yield investments can offer you high returns with controlled tax outflows.
3. Tax-efficient investing lets you invest in the right instruments to offer you higher returns:
Having the right investments on your portfolio can substantially improve your financial standing. By not ignoring the importance of tax efficient investing, you ensure that your money is invested in the right products. This happens when you think of your earnings in entirety and do not only consider the gross income but also the net income. Tax efficient investments aim at the inclusion of more tax friendly options in your portfolio to offer you increased returns. Hence, the focus is high on municipal bonds, treasury bonds, and strategies like tax loss harvesting.
How to save tax in investing?
In order to save tax in investing, it helps to pick suitable accounts and investments. Some of these are:
1. Exchange traded funds or individual stocks over mutual funds:
Exchange traded funds offer lower capital gains, as a result of which you pay fewer taxes too. Similarly, with individual stocks, you are in the position to make decisions on when to sell the stock. If you hold it for less than a year, the tax output would be more. This is because short term capital gains tax is levied at a higher rate. But if you hold it for more than a year, you will pay long term capital gains taxes that are comparatively low. These options add more authority to your investment plans and let you be in charge of how you are taxed. You can discuss these options with a financial advisor and set a timeline that can benefit you the most.
2. Treasury bonds:
Treasury bonds are another good example of tax efficient investments. There are no state income taxes levied on the returns from a treasury bond. So, you save a considerable amount that ultimately adds to your savings pool. Moreover, these bonds offer a guaranteed rate of return, so your invested capital also remains safe. As a result, you benefit on both fronts.
3. Municipal bonds:
Municipal bonds too are generally free from federal, state, and local taxes. However, this is only possible if you live in the same municipality as the municipal bond you invest in. Municipal bonds can particularly be useful for you, if you have already invested in retirement accounts that are likely to be taxed at the time of withdrawal. By adding these bonds to your portfolio, you will be able to create an additional source of income for your retirement with no tax liability at all.
In addition to this, you can also adopt some tax efficient strategies, such as:
1. Tax loss harvesting:
You can use your losses for tax loss harvesting and save on overall taxes. The loss incurred in the same financial year can be used to offset capital gains. You can also carry forward capital losses from the previous year. This is a common strategy. You can consult a financial advisor to know more about how this can benefit you.
2. Long term vs. short term capital gains taxes:
Holding your stocks for over a year can trigger long term capital gains taxes that are lower than short term capital gains that are charged if the stock was held for less than a year. Hence, holding for a little bit longer can result in better rewards.
Short term capital gains are taxed as per your ordinary income. On the other hand, long term capital gains taxes for 2021 are as follows:
|Tax rate 0%
|Tax rate 15%
|Tax rate 20%
|Up to $40,400
|$40,401 to $445,850
|Married filing jointly
|Up to $80,800
|$80,801 to $501,600
|Married filing separately
|Up to $40,400
|$40,401 to $250,800
|Head of household
|Up to $54,100
|$54,101 to $473,750
3. Charitable donations:
Donations not only benefit the receiver but also the giver. You can lower your tax liabilities by making donations. Instead of donating liquid money like cash, you can donate an appreciated mutual fund or stock.
To sum it up
It helps to understand the impact of taxes on your investments. This can only be done if you look at your investments along with their tax implications and then calculate your net income. Investments masked with high returns can seem like the right option sometimes, but they may not prove to be as rewarding after you pay taxes on them. Hence, it may be advised to keep a balance of high rewards and low tax on your portfolio at all times to earn maximized returns.
You can reach out to a professional financial advisor in your vicinity to understand more about tax efficient investing and how to incorporate it into your financial plan.