Tax efficiency - when discussed in divorce, portfolio construction, and investing in general - is how much of your money is left over after you’ve paid your taxes. How efficient was that investment to your personal bottom-line?
To understand how efficient a particular investment may be, a person must understand what they own inside the portfolio, but also how those instruments are taxed so they can efficiently calculate their true net income potential. At the end of the day, you need to understand how your investments are working for you and how your life is impacted by it.
There is often confusion around what is taxable, what is tax-deferred, and what is tax-exempt.
- Taxable accounts, such as a checking account that earns interest, would be subject to taxes on the interest.
- A tax-deferred account indicates investments which are sheltered from taxes as long as they remain inside of the account; for example, an Individual Retirement Account (IRA) or 401(k) plan. If those investments are taken out, those monies will be taxed at ordinary income tax rates.
- Tax-exempt investments are those not subject to federal or state taxation, such as income from a municipal bond.
The distinction is important to understand, especially in a divorce when a client might be reviewing an account for income potential. Income from a taxable account will be treated differently than a tax-deferred account, depending on the client’s tax bracket. A tax-deferred account may have growth, but taxes must still be paid when funds are withdrawn. A good question to ask oneself is: how much net income will this investment in this account yield me?
Each account has advantages and disadvantages. The first steps to becoming tax efficient and investing wisely is to understand your tax bracket; understand the classification - or “titling” - of your accounts; and understand the investments in your accounts and how they affect the income.
There is a common rule that the investor should protect inefficient investments in tax-deferred accounts (e.g., 401(k)s and IRAs), and tax-efficient investments in taxable accounts (e.g., brokerage or checking accounts).
Placing high-growth stocks, Exchange Traded Funds, and mutual funds in tax-deferred accounts like 401(k)s and IRAs can allow an investor to make trades, capitalize on profits, losses, etc. without the worry of taxes. Tax-inefficient accounts might be a good fit for municipal bonds since the income generated is tax free.
This is not a catch-all, but it can provide a guide for understanding. An investment advisor or your tax professional can help sort through the specifics in your individual portfolio.
We have a saying in our office: “Divorce forces you to put your financial house in order.” We say this a lot. Every investor can benefit from taking a hard look at what one owns, why it is in a particular account and whether or not it is even working for the needs and objectives of the investor.
Jennifer Failla, CDFA™
Principal, Strada Wealth Management
Toll Free: 866.526.7098