Tax Efficiency: Definition & Importance

KEY TAKEAWAYS

• Tax efficiency refers to when an individual or a business reduces the amount of tax they owe to pay the least amount that’s required by law. 
• Municipal bonds are exempt from federal taxes and tax-efficient mutual funds get taxed at a lower rate compared to other mutual funds. 
• There are various tax-deferred income-producing accounts individual taxpayers can use, such as a 401(k) plan or an Individual Retirement Account (IRA).

What Is Tax Efficiency? 

Tax efficiency is a strategy that a business or an individual can implement to try and pay the smallest amount of taxes. There are certain taxes that are required by law, but tax efficiency is a way to reduce this amount as far as it can go. 

When a tax outcome ends up being lower compared to another financial structure with the same goals, it’s considered to be tax-efficient. It can be a great way to reduce the total amount of tax that you know.

What Makes a Tax More Efficient? 

It’s not necessarily the tax itself that becomes more efficient, but rather the way you can structure an investment to get the best possible taxation. There are numerous ways you could do this to generate maximum tax efficiency. 

For example, let’s say that you open an annuity or an Individual Retirement Account (IRA). When you earn capital gains or dividends from your investment, they’re automatically reinvested back into your account. From here, it will continue to grow on a tax-deferred basis until you decide to make a withdrawal. 

How to Calculate Tax Efficiency

To best understand how to calculate tax efficiency, you first need to understand the tax efficiency ratio. The tax efficiency ratio measures the percentage of a fund’s earnings and how much of it is lost to taxation. The main purpose of mutual funds is to generate as much money for investors as possible. 

In order to calculate tax efficiency, you’re going to need to gather a few pieces of information beforehand. You’re going to need to find: 

• The annualized return of the fund
• The total amount of taxes paid on any distributions 

The calculations divide your tax-adjusted earnings by any pre-tax earnings. The formula to calculate tax efficiency would look like this: 

How to Maximize Tax Efficiency

It was mentioned above, but one of the biggest elements of tax efficiency is the strategy put in place for a specific investment. When you put the right investment in the right account, you can maximize the total tax efficiency. 

The majority of investment accounts can be separated into two primary categories. These are: 

• Taxable accounts — these can include the likes of brokerage accounts and they can be great choices for investment since they often lose fewer returns to taxes. 
• Tax-advantaged accounts — these accounts can include an Individual Retirement Account (IRA), a Roth IRA, or a 401(k). These types of accounts can be a good option for potential investments that might lose more of their returns to taxes. 

Essentially, picking the right investment and allocating the right amount of time to determine the best strategy is how you can maximize tax efficiency. Plus, it’s important to consider the timeframe you have and your risk tolerance. 

What Are the Criteria for Effective Taxation?

It can depend on the situation and the individual, but the criteria for effective taxation can vary. However, there are five conditions that should be met for taxation to be as effective as possible for every individual and business. 

The five criteria for an effective tax system include: 

• Fairness — This means that taxpayers should pay their fair share of taxes.
• Adequacy — This means that most taxes need to provide enough revenue to ensure the basic needs of society are met.
• Transparency — This means that any information about the tax system and how tax money is used is easily found and readily available for anyone who needs it.
• Simplicity — This means that taxation should be simple, not convoluted and confusing.
• Administrative ease — This means that the entire tax system should be easy to understand and affordable for both tax collectors and taxpayers. 

What Is a Tax-Efficient Mutual Fund?

Mutual funds are designed to make money, which is why they’re a popular choice with investors. If you don’t have a tax-free account or a tax-deferred account, investing in a tax-efficient mutual fund can help reduce your tax liability. 

Tax-efficient mutual funds get taxed at lower rates compared to other types of mutual funds. However, these types of funds often earn lower returns through capital gains and dividends compared to other mutual funds. 

For example, small-cap stock funds and other funds that get passively managed are prime examples of mutual funds that don’t generate high returns. These can include exchange-traded funds (ETFs) and index funds, for example. 

What Is Tax Efficient Investing? 

Investments, or capital property, can come in an array of forms. It could include investing in stocks, bonds, or property, for example. Tax efficient investing refers to making strategic investments in order to pay the least amount of taxes required by law. 

Not every investment is going to be created equal. This is especially the case when it comes to various types of taxes. And depending on how you invest, the taxes for different incomes can pile up quickly. For example, interest, dividends, and capital gains all get taxed differently. 

Some of the best options available to help you reduce the amount of taxes you owe include tax-advantaged accounts. These could be a tax free savings account (TFSA) or a registered retirement savings plan (RRSP). 

Summary

Tax efficiency is the process and strategy of paying the least amount of taxes that are required by law. For example, you could open an income-producing account like a 401(k). As you earn capital gains or dividends from your investment, you can continue to reinvest the amounts. 

Ultimately, your 401(k) account will continue to increase tax-deferred until you decide to make a withdrawal. This would be considered tax efficient since you’re paying the least amount of tax that’s required by law.