Maximizing Value With Tax-Efficient Investments
03 . 10 . 2020
Investors use a combination of tax-efficient and tax-inefficient investments to manage both the known and the unknown. That’s because savvy investors understand that market returns and tax law can’t be controlled, but they can be managed.
In this article we’ll discuss how to find the perfect blend of tax-exempt, tax-deferred, and taxable investments and why what’s tax-efficient for one investor may be inefficient for another.
Three main investment tax categories: what they are and how they work
Investments can be placed in one of three main tax categories. Here’s a quick look at what each category contains and how investors use them to minimize taxable income.
1. Tax-exempt investments
Sometimes known as “tax-free” investments, these tax-exempt vehicles allow investors to save more money to invest:
- Employer-sponsored retirement plans such as 401(k) and 403(b)
- HSA health savings account
- ETF exchange traded funds that are tax-free
- 592 Education Fund
- S. Savings Bonds
- Donations made to charitable organizations
- Real estate tax deferred 1031 exchanges
Municipal bonds are also normally tax free, but not 100% of the time. There are actually seven types of taxes that could apply to municipal (or muni) bonds including de minimis tax, alternative minimum tax, and capital gains tax.1
2. Tax-deferred investments
There are three main features to tax-deferred investments: Capital accumulates tax-free, contributions are tax deductible, and funds can be withdrawn after an investor retires at a lower tax bracket.
The most popular vehicles for deferring taxable income include:
- Roth IRA
- 401(k) plan
- Tax-deferred annuity
But tax-deferred investments can also create problems if an investor isn’t careful. For example, withdrawals could move an investor into a higher tax bracket, while a portion of Social Security income may become taxable based on how much “other income” a taxpayer has.
3. Taxable investments
Taxable investments are those that generate normal, ordinary income. Stocks and bonds (except for most municipal bonds), a certificate of deposit (CD) and money market accounts, and regular net income from real estate or REITs are some examples of taxable investments.
However, there are a variety of ways to reduce the taxes owed even when investments are taxable. U.S. News & World Report recently listed several ways to minimize taxes on taxable investments:2
- Keep short-term capital gains low by minimizing turnover of assets.
- Place municipal bonds and funds in taxable investment accounts.
- Strategically use charitable giving to reduce taxes.
- Cut income taxes by using tax-harvesting techniques.
- Optimize for tax efficiency by putting assets in their property category.
- Use tax-efficient index funds that make timing the market less tempting.
Tips for tax-efficient investments
To say that the IRS tax code is complex may be the understatement of the century. In addition to being thousands of pages long, there are also quirks in the tax code that can trigger shockingly high tax liabilities if one isn’t careful.3
Investors will be able to avoid many of the common tax traps that inefficient investments create by following these tips for tax-efficient investing:
- Retirement plans are the preferred vehicle for tax-efficient investing.
- Diversifying a portfolio with pre-tax and after-tax retirement plans, plus regular taxable investments, maximizes the level of tax efficiency and makes rebalancing easier.
- Investors in the top tax brackets usually see the most benefit from pre-tax plans, while those in the lower tax brackets benefit more by focusing on future untaxed cash flows.
- Store emergency funds in taxable accounts where withdrawals won’t create additional tax burdens.
- Keep tax-efficient and tax-free investments such as municipal bonds in taxable accounts since they normally don’t distribute capital gains.
- REITs and other tax-inefficient investments are best placed into retirement accounts where distributions can grow without being impacted by taxes.
- “Aggressive” investments that may create a loss should normally be placed in taxable accounts so that the tax benefits of the loss may be captured or “harvested”.
Why tax-efficient investments matter more to some investors than others
No investor wants to pay more taxes than necessary. By using tax-efficient investments to legally pay less tax, investors have more capital for investing in different parts of the capital stack and for portfolio diversification.
However, not all investors benefit equally from tax-efficient investments. In fact, an investment that is tax-efficient for one investor may actually generate more taxable income for another.
When weighing the advantages of alternative investments, it’s important to keep in mind that the tax efficiency of investments is relative. Two important factors to review when looking at tax-efficient investments are individual tax bracket and the difference between short- and long-term capital gains.
Individual tax bracket
Generally speaking, investors who are in the upper income tax brackets benefit more from tax-efficient investments than people in lower tax brackets. For example, investors with a marginal tax rate of 12% receive less tax savings in real dollars than those in the higher tax brackets.4
Short-term vs. long-term capital gains
Selling an asset that creates a capital gain can have the unintended consequence of increasing an investor’s taxable income and potentially moving the taxpayer into an even higher tax bracket.
That’s because the profits generated from an asset held less than one year before it is sold are short-term gains and taxed as normal income. On the other hand, capital gains from assets held longer than one year are taxed at a 15% long-term capital gains rate for most taxpayers.5 Treating a short-term gain as normal income has a disproportional affect on upper income investors versus those in the lower tax brackets.
Four additional ways to improve investment returns
Choosing tax-deferred and tax-exempt investment options help investors minimize and delay taxes. Investors can also employ four additional strategies to improve the returns on individual investments:
- Timing the sale of an asset to generate a long-term capital gain at a lower tax rate.
- Intentionally generating a loss from a non-performing asset to help offset the tax payable on a more profitable investment.
- Carrying forward a tax loss to reduce future tax payments.
- Deducting up to 50% of adjusted gross income by making charitable contributions to qualified organizations.6
Rebalancing a portfolio to increase tax efficiency
Assets placed into tax-efficient, tax-deferred, and taxable accounts don’t always remain in the same place as the years go by. There are various reasons why asset sales and substitutions occur, usually due to tax planning strategies or maintaining asset allocation targets among different asset classes.
Normally, rebalancing an investment portfolio is tax inefficient. That’s because asset sales may generate taxable gains.
However, there are several tactics investors can use to rebalance a portfolio without sacrificing tax efficiency.
Generate gains within tax-efficient accounts
One technique is to sell appreciated assets within a retirement account so that gains are not immediately taxed. As long as no withdrawal is made, not tax will be due. This is also a reason why many investors choose to hold a variety of different asset classes in both taxable and tax-efficient accounts.
Rebalance with contribution re-allocation
Rebalancing a portfolio by re-allocating new funds to different asset classes is another way to avoid taxable gains. Instead of selling appreciated assets, an investor can simply put money into assets that are underrepresented.
For example, if the targeted allocation balance of 50% real estate and 50% stocks and bonds has become unbalanced, rebalancing can be achieved by overweighting future contributions toward the under-balanced asset class until the desired split has been restored.
Why real estate investors love the IRS
Although the Internal Revenue Code is complex, it’s also very friendly to commercial real estate investors.7Take capital gains, for example.
Normally, long-term gains from the sale of stocks, bonds, and real estate are all taxable.
However, Section 1031 of the Internal Revenue Code allows investors to defer the payment of capital gains tax by reinvesting those realized gains into another investment property. The net result is that investors have more capital to invest when capital gains tax is deferred.
Investing in Opportunity Zones is another way that real estate investors can realize multiple tax benefits.8
Opportunity Zones (or OZs) were created by the Tax Cuts and Jobs Act of 2017 (TCJA).9 The U.S. Treasury Departments approved around 10,000 Opportunity Zones in all 50 U.S. states, and U.S. territories, to spur investment in lower-income, underdeveloped and underserved communities.
By using a 1031 exchange to invest the proceeds from a relinquished property into an Opportunity Zone investors can defer payment on any capital gain. In addition, they can also step up the basis of the relinquished property and potentially owe no tax on future gains from the Opportunity Zone investment.
Other tax benefits of real estate investing
- Deduction of normal business expenses helps reduce taxable net operating income.
- Mortgage interest payments can be deducted from gross operating income.
- Non-cash deductions for depreciation and amortizationallow investors to reduce or completely eliminate taxable income while still generating free cash flow.10
Making the capital stack tax-efficient
Oftentimes real estate investors, developers, and sponsors feel as if they’re caught in a battle of tug-of-war when choosing the right capital structure of debt and equity.
To be sure, there are definite advantages to debt.
Interest expense is tax deductible and returns can be increased with the strategic use of debt. Debt also allows investors to reduce the after-tax cost of capital which indirectly can increase the intrinsic value of a project.
However, too much debt in the overall capital stack can reduce cash flow if the mixture of debt and equity isn’t correctly balanced.
When this occurs, there’s less money available to add value, invest in capital expenditures, and for sales and marketing. The end result is that a project’s value can actually decline when capital is stacked incorrectly.
Managing the capital stack to maximize both tax efficiency and project value can become a balancing act that is best left to performers with years of experience in the business.