Every investment has its own costs. Among all of the expenses involved, taxes usually sting the most. Kavan Choksi mentions that for many investors, taxes take the biggest bite out of their returns. Hence, most savvy investors explore options for tax-efficient investments. Tax-efficient investing can go a long way in reducing the tax burden of the investor while maximizing their bottom line, no matter whether they want to generate cash or save for retirement.
Kavan Choksi briefly talks about tax-efficient investing
Asset allocation and investment selection are undoubtedly two of the most important factors that impact investor returns. However, the tax incurred by the investors also has a major influence on their earnings. After all, not only do the investors lose money when they pay taxes, but they also lose the growth that money could have generated if it were still invested.
For most investors, the after-tax returns matter way more than the pre-tax returns. It is those after-tax dollars that they would be spending both now and during retirement. If an investor desires to maximize their returns and keep more of their money, exploring tax-efficient investment options is immensely important. The majority of the investors would know that if they sell off an investment, they are likely to owe taxes on any gains. However, there is also a chance that they can be on the hook if their investment distributes its earnings as dividends or capital gains, no matter whether they sell off the investment or not.
As pointed by Kavan Choksi, by nature, some investments are simply way more tax-efficient than others. For instance, among stock finds, exchange traded funds (ETFs) and tax-managed funds are known to be more tax-efficient as they trigger lesser capital gains. On the other hand, actively managed funds ideally purchase and sell off securities much more often. As a result, they have the potential to generate more capital gains distributions, and invariably incur higher taxation. Bonds are another great example. Municipal bonds are extremely tax-efficient as the interest income involved is not taxable at the federal level. Moreover, very often, these bonds are tax-exempt at the state and local levels as well. Due to this feature, municipal bonds are often referred to as triple-free. Such bonds are great candidates for taxable accounts as they are already tax efficient. Treasury bonds and Series I bonds are also tax-efficient as they are exempt from state and local income taxes. Corporate bonds, however, do not have any tax-free provisions.
One of the key principles of investing, no matter for saving for retirement or simply growing wealth, is to minimize strategy. A robust strategy for reducing taxes would involve holding tax-efficient investments in taxable accounts and having less tax-efficient investments in tax-advantaged accounts. This would provide the investors with the best possible opportunity to grow their accounts over time. However, even if it is a smarter move, in general, to keep an investment in a tax-advantaged account, there are instances where the investor may have to prioritize some other factor over taxes. For instance, a corporate bond might be better suited for the investor’s IRA, but they may choose to hold it in their brokerage account to maintain liquidity.