Tax Efficiency

  

Categories: Tax

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.

Related or Semi-related Video

Finance: What is a Tax Deduction?102 Views

00:00

Finance allah shmoop shmoop What is a tax deduction Uh

00:06

taxes Love him Hate him You can't leave him but

00:10

you can lower them legally by being you know thoughtful

00:13

about how you spend your earnings All right How do

00:16

we do this Well let's start with the largest tax

00:18

deduction in america the home mortgage And you you the

00:23

dentist who makes one hundred fifty grand a year for

00:26

putting your fingers in wet mouth Well remember that for

00:29

individuals versus corporations we pay a graduated or quote progressive

00:35

unquote tax rate Like almost nothing On the first fifteen

00:39

grand we earned on about ten percent from fifteen to

00:42

thirty grand And then about twenty percent from thirty to

00:44

sixty grand And so on That's progressive So on the

00:47

last twenty grand of earnings you make well you might

00:50

pay say forty percent in taxes and yeah we know

00:53

the numbers own exact We're just illustrating a point Here

00:56

you have a mortgage of three hundred thousand dollars on

00:58

a home you bought for four hundred thousand dollars right

01:01

So you put a hundred grand down and borrow three

01:03

hundred The mortgage costs you six percent per year in

01:06

interest or eighteen thousand dollars to rent that three hundred

01:09

thousand before you owned the home The irs thought of

01:13

you as one hundred fifty grand a year earner but

01:16

one hundred percent of the interest on the home is

01:19

fully tax deductible So what about that last twenty grand

01:23

iii The money you earn from one hundred thirty k

01:26

to one hundred fifty k Well as faras the irs

01:29

is concerned now that you have a home you get

01:31

taxed as if you earned just one hundred thirty two

01:35

grand not one hundred fifty k actually earned Why Because

01:39

that eighteen thousand dollars in interest comes right off the

01:43

top of your earnings See there's the math right there

01:46

one hundred fifty minutes eighteen hundred thirty two taxable earnings

01:48

it's as if you didn't earn that money ever can't

01:55

all right well if you'd had no deductions on that

01:57

last twenty thousand dollars of earnings you'd have paid forty

02:00

percent or eight thousand dollars in taxes But now on

02:04

that last twenty thousand dollars thanks to your mortgage deduction

02:07

well you only have taxable income of two thousand dollars

02:11

And yes you pay forty percent on that two thousand

02:14

Or eight hundred bucks And you mumbled thank you government

02:17

for largely splitting the cost of my mortgage with me

02:20

The american dream is alive and well that's what you

02:23

say Okay And thank you jay There are other deductions

02:26

beyond home mortgages of course but well you get the

02:29

gist here of how they work from a taxpayer's perspective

02:33

Deductions like those from your home mortgages are a good

02:36

thing Common personal deductions also include things like prepaid healthcare

02:41

costs and the cost of feeding quote dependent unquote children

02:45

Aii those noisy things sleeping in your spare bedrooms until

02:49

they're eighteen Okay so those air personal deductions things that

02:52

individual citizens take But what if you're a corporation Well

02:56

in a way it's kind of easier Think of most

02:58

corporations is having a flat thirty percent tax from the

03:01

first dollar they make just keep things simple Participation trophy

03:04

company in kameda one hundred million dollars last year and

03:08

paid thirty million in taxes They netted seventy million after

03:12

tax The company really needs a new trophy smelting machine

03:16

because with so much demand for participation trophies of late

03:20

while the old one is running dullah with mediocrity the

03:24

company spends forty million box on the new machine knowing

03:27

that it will be worthless in ten years either because

03:30

it wears out or because the country gets riel or

03:33

you know simply remembers to you know have a nice

03:35

day participation trophy land Welcome to it They'd appreciate forty

03:39

million dollars in equal parts of four million box each

03:42

year over ten years so that in the next year

03:45

when they again or in one hundred million dollars well

03:47

they now get to deduct four million bucks and appreciation

03:51

from their smelting machine against their hundred million dollars in

03:55

earnings So again as faras the irs is concerned they

03:58

didn't really earn one hundred million dollars even though they

04:00

did They earned quote on ly unquote ninety six million

04:04

and yes they still pay their thirty percent tax Only

04:07

now instead of paying it on a hundred million bucks

04:09

it's paid on ninety six million of earnings or point

04:13

three times ninety six or twenty eight point eight million

04:17

in taxes they did Abducted from their taxes The four

04:21

million box expected value decline from their smelting machine Right

04:25

It goes down four million a year in value from

04:27

the forty they paid They received essentially a credit on

04:30

their taxes of one point two million dollars So instead

04:34

of that year's depreciation costing the company four million bucks

04:38

well it really cost them more like two point eight

04:41

million If you ignore a bunch of other things like

04:42

the original capital cost of the machine what else they

04:45

might have done with that money oven you know via

04:48

smelting machine Think think Corporate jet Yeah those g sixes 00:04:52.774 --> [endTime] are surprisingly tasteful

Up Next

Finance: What is the IRS?
19 Views

Time to learn about the IRS. On the bright side, it'll be less painful than an STD, less emotionally manipulating than PMS, and less time-consuming...

Finance: How Does Depreciation Affect Taxes?
40 Views

How does depreciation affect taxes? Depreciation accounts for a company’s assets losing their value over time. Companies are able to factor this...

Finance: What is Double Declining Balance Depreciation?
10 Views

Double declining balance sheet depreciation is a structure of formula under which companies assess the depreciating value of an asset that loses va...

Find other enlightening terms in Shmoop Finance Genius Bar(f)