Investing Primer: Tax Efficiency

“In this world nothing can be said to be certain, except death and taxes.” 

                                                                 - Benjamin Franklin

This is the sixth post in my investing series: 

Part 1: save, save, save
Part 2: stocks and bonds
Part 3: risk, asset allocation, diversification
Part 4: mutual funds and ETFs

Part 5: minimizing costs

Some investments are more tax efficient than others, which means you have less tax to pay.  And the less taxes you pay, the more money you get to keep.  Armed with this information, you can organize your investment portfolio in a way that minimizes taxes.

Tax Advantaged Accounts  

Many investors saving for retirement should start by contributing to tax advantaged accounts such as 401ks and IRAs.  These tax-advantaged accounts allow your investments to compound and grow without taxes taken out each year.  For 2013, if you're under 50, you can contribute a maximum of $5,500 in your Traditional or Roth IRA and $17,500 in your 401k or 403b accounts.  That’s $23,000 in tax advantaged investments per year!

Refresher on retirement accounts:

401(k) / 403(b) accounts are tax-deferred: no taxes are paid on investment earnings within the account, but there will be income taxes on withdrawals in retirement

Roth IRA accounts are tax-free:  you make contributions with after-tax money, so withdrawals are tax free in retirement if you’re 59 ½ or older and have held your Roth IRA account for at least 5 years

Traditional IRA accounts are tax-deferred: your contributions may be tax deductible but you'll pay income taxes when you make withdrawals in retirement

As I mentioned earlier, some investments are more tax efficient than others.  This being said, many investors may never need to worry about tax efficient placement of investments since tax-advantaged accounts have plenty of space to hold all of their retirement savings.

When investing in your retirement account(s), you should first invest in your company 401k up to the match (for the free money), then max out your IRA.  If you have more money left over, go back and contribute to your 401k.  

If you expect to work past age 60 and place all your investments into tax-advantaged accounts, fund placement does not have a large tax impact on your investment returns.  You can stop reading this article now and move on.

If you have a taxable account, you should consider tax efficiency when choosing investment options.  

What’s a taxable account?

A taxable account means that any income earned in the account is "taxable" at the time of earning.  You can open a taxable account at Vanguard as well as other investment firms.  If you have a savings account that earns interest, then you already have a taxable account.

Generally speaking, it is most tax efficient to fully fund your 401k and Roth or Traditional IRA before you fund your taxable accounts.

Why open a taxable account?

There are plenty of reasons.  Not everyone has access to a company sponsored 401k account.  If your only tax-advantaged account available is an IRA, then you can only invest $5,500 a year.  If you want to invest more, you'll need to open a taxable account. 

Some 401k accounts don’t offer any company match, or may have limited or expensive choices.  Poor funds or high fees may not significantly offset the tax advantage of investing in your 401k plan. 

What if you want to retire early?  

Retirement accounts are meant for retirement after 59 ½ only.  You can’t just take money out of your tax-advantaged retirement accounts early without incurring tax consequences*:

Roth IRA: There is 10% federal penalty tax on withdrawals of earnings before age 59 ½.

Traditional IRA: There is a 10% federal penalty tax on withdrawals of either contributions or earnings before age 59 ½. 

*Some qualified exceptions on tax-free withdrawals of IRA funds before you’re 59 ½ include: first-time home purchase ($10,000 limit), certain medical expenses, and postsecondary education expenses.  This is not your savings account and I don’t recommend using your IRA for anything other than what it was originally designed for: your retirement.

Required Minimum Distributions

With a Traditional IRA and 401k, you are forced to start making required minimum distributions of your money after you turn 70 ½.  You can’t keep the money growing in those accounts.  With a taxable account, here are no contribution limits no matter your income.  You can withdrawal money from your taxable account at any time without penalty other than taxes.  There is no required minimum distribution of your taxable account money.  

Having both tax-advantaged and taxable accounts

If you have both taxable and non-taxable investment accounts, you should separate the types of investments you choose to hold in your accounts.

Some funds like total stock market index funds are extremely tax-efficient because they produce very low dividends and capital gains.  These index funds are passively managed, and don’t have active trading managers who are constantly buying and selling stocks in the portfolio, incurring short term gains taxes.  These types of stock index funds should go in your taxable account.

If a fund manager sells stocks within a mutual fund for a net gain, the gains are distributed and taxable; if you hold stock investments for less than 1 year, you will be subjected to significant short-term capital gains taxes (taxed as ordinary income).  If you hold stock investments over 1 year, then you will be taxed at 15%, the long-term capital gains tax.

Bonds and bond funds tend to be extremely tax-inefficient since they produce dividend yields and interest that is taxed at your full marginal tax rate (ordinary income).  Since bond funds are considered tax inefficient, they should go into tax-advantaged account(s).

Actively managed stock funds with high turnover sell most of their stocks with gains, generating large taxable gains.

I’ve only briefly touched upon tax efficiency between different types of investments.  If you want to read a much more thorough and overly complicated version of tax efficient fund placement, I recommend reading the Bogleheads wiki guide here.  Otherwise, the information that I've posted on tax efficiency here should be sufficient for our needs.

The take home message of the Bogleheads wiki guide to tax efficiency is in this picture:

The most important thing to remember is that while we can’t control how the stock or bond market is going to perform, we can focus on money saving decisions that are within our control, such as optimizing tax efficiency.  

Don’t forget to take advantage of your tax-advantaged accounts before you decide to open a taxable investment account.

My next post will be on market timing, and why you should never do it.