Realizing the important benefit of limiting the costs of investing is a fundamental principle for improving investment returns, A careful focus on tax efficiency is a way to cut the bite that taxes take from our nest eggs.
The value of tax deferral
The most important rule for tax efficiency is to take full advantage of tax-advantaged accounts. These allow your money to grow, using the magic of compound interest, without a portion being removed every year to pay taxes.
The following example compares a hypothetical investment of $10,000 in a taxable investment (such as a bond or CD) returning 6% annually for 5 years. The investor is assumed to be in the 25% tax bracket both during the investment and the withdrawal stage.
Holding the investment in a tax-deferred account waits until the investor withdraws the funds, and then taxes are paid on the entire, cumulative amount of gains. In a taxable account, the 25% tax is paid each year on the gains for that given year.
After five years, deferring the taxes yields an after-tax amount of $12,537 for this hypothetical investor, while paying taxes each year yields an after-tax amount of $12,462. Having a tax-deferred account has returned $75 more than a taxable account.
|5||6%||25% (of total return)||$757||$846||$12,537|
Taxes and taxable accounts
In the U.S. if you hold investments in a taxable account, you are subject to taxes for your annual interest, dividend, and realized capital gains income, according to the reigning tax law when you receive the income.
Under current law, “qualified” stock dividends and long-term capital gains/distributions are taxed at lower (0% to 23.80%) tax rates by the federal government.
Bonds in the taxable account
For a bond or a bond mutual fund held in a taxable account, the interest paid is taxable in the year of its receipt. The tax imposed depends on the issuer of the bond. Generally, bonds are taxed as follows.
- Corporate bonds issued by businesses are taxed by both the federal government and state governments.
- US Treasury bonds issued by the US Treasury are taxed by the federal government but are not taxed by the states. US savings bonds (both series EE and series I) allow for tax deferral of interest accumulation for up to thirty years.
- Municipal bonds issued by states and municipalities are generally exempt from taxation by the federal government. A municipal bond is subject to state income tax unless you hold a bond issued by your state of residence. In this case the bond is free from state tax.
The main determinants of the tax paid on bond interest are the amount of interest and your marginal tax rate (both federal and state) . The higher your tax rate and the higher the interest rate, the higher the tax.
Given the risk and tax implications of bond subclasses, corporate bonds usually have higher yields than do treasury bonds. Municipal bonds usually have lower yields due to the federal tax exemption.
You can use a bond tax calculator to decide which bond or bond mutual fund gives you the highest after-tax yield.
Keep in mind that bonds and bond mutual funds are also subject to capital gains taxation. When interest rates fall, bond prices rise; when interest rates rise, bond prices fall. Your sale of a bond or bond mutual fund may result in a realized taxable gain or a realized loss.
Stocks in the taxable account
Stocks and stock mutual funds are subject to taxation of dividends, capital gains, and for mutual funds, capital gains distributions. Under current law, “qualified dividends” and long-term capital gains are taxed at lower rates.
Additional tax-related aspects primarily affecting stock investments include:
- Capital gains taxes are not imposed on charitable donations of appreciated stocks or appreciated stock mutual fund investments.
- Appreciated stock and stock mutual fund investments receive “step-up valuation” to current market value upon the death of the owner.
- An investor can claim a foreign tax credit for taxes paid to foreign governments on international stock investments.
- Investments that are sold for a loss can be used to offset taxable gains or taxable income , subject to annual limits. (See notes for links to detailed discussion of tax-related selling of investments).
Tax-efficient stock market funds
Broad-market index funds held in taxable accounts offer investors much greater after-tax returns than do most actively managed funds.
John Bogle, in his book, The Little Book of Common Sense Investing, devotes a full chapter to the costs that taxes impose on mutual fund investors.
He compares the results of investing $10,000 in both an S&P 500 index fund and the average actively managed mutual fund from 1980 – 2005. Actively managed fund distributed many more annual capital gains distributions to investors than did the passively managed S&P 500 index fund.
The market returned an annualized compound return of 12.3% over the 1980 -2005 period.
For the full period, the corrosive combination of mutual fund expenses, annual tax payments, and inflation resulted in the S&P 500 fund producing an annual real after-tax return of 8.4% compared to the 4.9% annual real after-tax return of the average managed fund. (Taxes would be imposed on the S&P 500 index fund upon a liquidation of shares; this would lower the annual compound return by roughly 0.50% – 0.75%.)
Terminal wealth: $10,000 initial investment, 1980 – 2005
|Gross return||Pretax return||After-tax return||Real return|
Relative tax efficiency of asset classes
Investors having both tax-advantaged and taxable accounts can use the following ordering for guidance on the placement of assets in accounts. Prioritizing less tax-efficient assets in the tax-advantaged account and tax-efficient assets in the taxable account can serve to reduce the tax drain on your portfolio’s returns.
- Low-yield money market, cash, short-term bond funds
- Tax-managed stock funds
- Large-cap and total-market stock index funds
- Small-cap or mid-cap index funds
- Value index funds
- Moderate-yield money market, bond funds
- Total-market bond funds
- Active stock funds
- Balanced index funds
- Real estate or REIT funds
- High-turnover active funds
- High-yield corporate bonds
Refer to the following pages, courtesy of the Bolgeheads Wiki, for detailed information about tax management in a taxable account.
- Timing of transactions to reduce taxes
- Tax loss harvesting
- Tax gain harvesting
- Cost basis methods
- Specific identification of shares
- Wash sale
- Donating appreciated securities