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Tax-efficient investment: Tips for the individual investor

Every investment comes with a price tag. Out of all the expenses, taxes take the greatest bite out of your returns. The good news is that tax-efficient investing may help you reduce your tax burden whether you're trying to save for retirement or make money.

In this article, we will discuss how taxes impact your investments and how you should invest your money tax-efficiently:

1. What are the two most common types of investment accounts?

The Schwab Center for Financial Research examined the long-term impact of taxes and other fees on investment returns. It concluded that while asset allocation and investment selection are the most important aspects, reducing taxes also has a considerable effect. This is because the money you paid in taxes is already gone, and you missed out on the potential growth that money could have created if it had remained invested. Hence, your post-tax returns are more important than your pre-tax returns because you only get to spend the money after paying taxes.  

The two most common types of investment accounts are taxable accounts and tax-advantaged accounts. Taxable accounts do not provide any tax benefits but, they are more flexible in terms of investment. They have fewer restrictions in management and are generally created through online brokerages (for example, Vanguard, IB and Degiro). Taxable accounts allow you to withdraw your investment principal at any time without paying any taxes or penalties. 

Tax-advantaged accounts can have either taxes deferred or exempted, meaning you will get an upfront tax break from deducting your contribution to the account. A good example of one is voluntary pensions. You only pay taxes when you withdraw all of your money before your retirement. By retirement, the tax rate will be much lower because you will not have additional income to tax. Tax-advantaged accounts have annual contribution limits. Therefore, it is ideal for holding your investments in tax-advantaged accounts. But it may not be ideal for every investor due to the contribution restrictions and the general lack of flexibility.  

2. How can you invest tax-efficiently?

Depending on the jurisdiction, you may have to pay taxes on the gains if you sell your investment. You will also be taxed on the earnings of your investments whether you sell them or not. Most investors prevent this by holding their investments to avoid short-term capital gains tax and reinvesting their earnings. Compounding is one of the most commonly preferred methods, not only because it grows significantly with time but also that it reduces your taxable gains as your investment grows. The increase in earnings and reduction in tax payments result in significant growth in your investment. 

However, some investment assets are more tax-efficient than others which you can choose from the start. There are tax-managed funds specifically designed to lower taxes on your investments by not buying dividend-based stocks, selling some of them at a loss to offset gains, or holding on to the stocks. ETFs are also a tax-efficient investment because they trigger fewer capital gains. Bonds, especially municipal bonds, are not taxed at a state level on income. Municipal bonds are issued by the government to fund state projects. Corporate bonds, however, do not fall under this and is better off invested under tax-advantaged accounts like under voluntary pensions. Actively managed funds, however, are not as tax-efficient because they trade more often and incur more capital gains taxes for you.

3. How can you reduce taxes?

Not everyone may want to or have the circumstances to invest their money. You may rather want to invest in your business. Suppose you have a business and you want to reduce your taxes. In that case, the only suitable and legally acceptable way is to increase your company expenses and write your spendings off under business-related expenditure. This will decrease your income and reduce your taxes correspondingly.  

If you would like to buy a home, there are a lot of tax saving methods. However, it depends on the jurisdiction you are in. Some countries allow tax breaks on mortgage payments. Some save on capital gains from selling a home and moving to a new primary residence, especially if your new home needs renovations or improvements. 

Many investors are eager to learn about the next market-beating investment opportunity, but few make the same effort to reduce taxes. Astute tax management is an important part of any effective financial plan. Make sure that you're doing everything you can to keep your money. Also, consult a tax advisor: your tax savings may result in a significant increase in your annual return.

Last update: 31/01/2022

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Disclaimer: Some text on this website is purely for marketing communication. Nothing published by Quanloop constitutes an investment recommendation, nor should any data or content published by Quanloop be relied upon for any investment activities. Quanloop strongly recommends that you perform your own independent research and/or speak with a qualified investment professional before making any financial decision.