Tax Efficiency

Just as naturally as the wind blows through the trees, financiers will find their least-tax financial option.

In the world of finance, there are lots of ways to finance projects and move money around. You might want to fund a new venture...but with what funds? Equity? Or taking on debt? And from where? Or maybe you’re just setting up an investment, but want to do so with the smallest possible fees and taxes attached.

Financial transactions are said to be tax-efficient if they have the lowest amount of taxes relative to other financial transactions used to achieve the same goal. Taxes, like everything else (labor, materials, equipment, etc.), are just another cost of doing business. As with all costs, they’re most efficient if they’re minimized...getting the biggest bang for your buck, so to speak.

The U.S. government knows people try to be tax-efficient with its investments, which is why they created retirement vehicles like 401(k)s and Roth IRAs/OG IRAs. These retirement funds are set up with tax benefits, encouraging working people to save up for retirement. Likewise, you’ll get penalized in most cases for tapping your 401(k) or IRA early. For your average American Joe, maxing these accounts out first is your most tax-efficient bet in terms of saving money.

While mutual funds have dominated the responsible, long-term investing market for a while now, ETFs have largely disrupted this scene, in part because many ETFs are more tax-efficient than their mutual fund counterparts. For the most part, not only are ETFs not passively managed, but their structure of fewer long-term capital gains redistributions makes ETF-holders subject to less tax compared to an equivalent mutual fund. That is, ETFs don't realize gains; they just buy and hold "forever."

Setting up trusts, buying tax-free bonds, and strategically timing the cashing out of investments are all aimed at maximizing tax efficiency. Why not? The alternative is just handing over yet more of your hard-earned money to Uncle Sam.