March 6, 2015
What makes an investment option tax efficient vs. tax inefficient? Examples?
What makes an investment option tax efficient vs. tax inefficient? Examples?
What makes an investment tax efficient or tax inefficient is what type of income you are making off of it. If you own index funds then you make capitol gains which are taxed at a much lower rate than earned income. If you invest in annuities they are taxed the same as earned income which makes them very tax inefficient.
Tax efficiency or inefficiency is a measure of how much of your return is left over after taxes. If there is a low rate of taxes being withheld, your investment is more efficient. On the other hand, if there is a high rate of taxes being withheld, your investment is less efficient. In short, tax efficiency is essential to maximizing your returns.
An example of an inefficient investment would be a junk bond because their yields are taxed at the same rate as ordinary income. An efficient investment would be common stocks (that are held more than one year) because they are taxed at the capital gains rate, which is much lower than the tax rate for ordinary income.
How you get money out of an account affects the tax efficency. If you are getting dividends or interest. For most stock accounts you are getting dividends that are federally taxed at a lower rate. While on REITS and bonds on the other hand pay interest that is taxed like normal income. How ofter stocks are bought and sold affect the tax efficiency also. You want an account with low turnover if it is taxed, such as the total stock market index.
This is not an easy question to answer. There were some money good points made in your responses. Let’s recap.
(1) A tax efficient investment provides little in the way of yearly income (taxes and short-term capital gains). Examples of mutual funds that fit this criteria would be a Total Stock Market Index Fund or a Total International Stock Index Fund.
(2) A tax inefficient investment provides a bunch of yearly income which you will have to pay tax on. Examples of mutual funds that fit this criteria would be REITs and bond funds.
(3) Focus on keeping tax efficient funds outside of retirement accounts and tax inefficient funds inside retirement accounts like a 401(k) or a Roth IRA. Educate and ACT.