Tax Efficiency: Definition & Importance

KEY TAKEAWAYS

• Tax efficiency refers to a reduction in the amount of tax that an individual or business is required to pay to a government.
• Municipal bonds are exempt from federal taxes and tax-efficient mutual funds get taxed at a lower rate compared to other mutual funds.
• There are various tax-deferred income-producing accounts individual taxpayers can use, such as a 401(k) plan or an Individual Retirement Account (IRA).
• A tax efficient strategy can be created by selling securities at a loss to offset securities sold at a gain.

What Is Tax Efficiency? 

Tax efficiency is a strategy that a business or an individual can implement in order to pay the smallest amount of taxes. Although paying income and investment taxes is required by law, tax efficiency is a way to reduce the taxable amount as far as it can go. 

When a tax outcome ends up being lower compared to another investment structure with the same goals, it’s considered to be tax-efficient. It can be a great way to reduce the total amount of tax that you owe.

What Makes a Tax More Efficient? 

It’s not necessarily the tax itself that becomes more efficient, but rather the way you can structure an investment to create the best possible tax effect. There are numerous ways you could do this to generate maximum tax efficiency. 

For example, let’s say that you open an annuity or an Individual Retirement Account (IRA). When you earn capital gains or dividends from your investment, they’re automatically reinvested back into your account. From here, it will continue to grow on a tax-deferred basis until you decide to make a withdrawal.

How to Calculate Tax Efficiency

To best understand how to calculate tax efficiency, you first need to understand the tax efficiency ratio. To create a tax efficient investment, one must not only look at the total return but also at the return after taxes are applied. The tax efficiency ratio measures the percentage of a fund’s earnings and how much of it is lost to taxation. 

In order to calculate tax efficiency, you’re going to need to gather a few pieces of information beforehand. You’re going to need to find: 

• The annualized return of the fund
• The total amount of taxes paid on any distributions 

The calculations divide your tax-adjusted earnings by any pre-tax earnings. The formula to calculate tax efficiency would look like this:

A higher efficiency ratio means that the investment is more tax efficient.

How to Maximize Tax Efficiency

One of the biggest elements of tax efficiency is the strategy put in place for a specific investment. When you put the right investment in the right account, you can maximize the total tax efficiency. 

The majority of investment accounts can be separated into two primary categories. These are: 

• Taxable accounts — these can include the likes of brokerage accounts and they can be great choices for investment since they often lose fewer returns to taxes. 
• Tax-advantaged accounts — these accounts can include an Individual Retirement Account (IRA), a Roth IRA, or a 401(k). These types of accounts can be a good option for potential investments that might lose more of their returns to taxes.

What Is a Tax-Efficient Mutual Fund?

Mutual funds are designed to make money, which is why they’re a popular choice with investors. If you don’t have a tax-free account or a tax-deferred account, investing in a tax-efficient mutual fund can help reduce your tax liability. 

Tax-efficient mutual funds try to maximize the long-term appreciation instead of concentrating on dividend distribution, which would be taxed at a higher tax rate. The long and short term capital gains or losses don’t depend on how long you held the mutual fund, but rather on how long the fund held a certain asset. The funds managers try to reduce the short-term and higher taxed gain by avoiding buying and selling of the funds assets. If a fund holds their assets for more than a year, the gains will be taxed with a lower long term capital tax rate.

What Is Tax Efficient Investing? 

Investments can come in an array of forms. One can invest in stocks, bonds, or property. Tax efficient investing refers to making strategic investments in order to pay the least amount of taxes required by law. 

Not every investment is going to be created equal. This is especially the case when it comes to various types of taxes. It depends on your investing strategy, and your ultimate goal. For example, interest, dividends, and capital gains all get taxed differently depending on the length of your investment and your adjusted gross income. 

Some of the best options available to help you reduce the amount of taxes you owe include tax-advantaged accounts. These could be a tax free savings account (TFSA) or a registered retirement savings plan (RRSP).

Summary

Tax efficiency is the process and strategy of paying the least amount of taxes that are required by law. For example, you could open an income-producing account like a 401(k). As you earn capital gains or dividends from your investment, you can continue to reinvest the amounts. 

Ultimately, your 401(k) account will continue to increase tax-deferred until you decide to make a withdrawal. This would be considered tax efficient since you’re paying the least amount of tax that’s required by law. 

Written by Sandra Habiger

Sandra Habiger is a Certified Public Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Learn more about her work at https://www.sixfiguresaccounting.com/ .

Written by Sandra Habiger

Sandra Habiger is a Certified Public Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Learn more about her work at https://www.sixfiguresaccounting.com/ .