By John Ohe
The basic idea behind tax-efficient investing is to structure your investments such that taxes are minimized. Often times, we see opportunities when reviewing investment account statements provided by our tax clients (many of whom use financial advisors).
There is an important saying: “It’s not what you earn, but what you keep.” With that in mind, let’s begin by summarizing some basic investment management principles.
Investments generate returns – capital gains, dividends, and interest. Generally speaking,
capital gains are more tax efficient than dividends and interests. That is because capital gains can be deferred until the investment is sold, and long-term gains are subject to a lower tax rate.
However, there are certain mutual funds and managed accounts (sold by financial advisors) with high churn or turnover – lots of buying and selling within the fund or portfolio. These generate distributed capital gains on which the investor needs to pay taxes. People are often surprised by the large capital gains that appear in their year-end statements from their mutual fund companies or brokerage firms.
As a general rule, you should structure your investment portfolio into two buckets:
- Put “less tax-efficient” investments into retirement accounts; and
- Put “more tax-efficient” investments into taxable accounts
The following list provides a good snapshot:
Types of Investments to put into retirement accounts (tax deferral)
Inefficient
High-yield corporate bonds
High-turnover active funds
Real estate or REIT funds
Moderately Inefficient
Active stock funds
Bond funds
Types of investments to put into taxable accounts
Efficient
Index funds
Tax-managed funds
Short-term bond funds
Low-yield money market
Tax-efficient investing does not factor individual circumstances. For example, if you needed access to funds for a planned expenditure, then putting those funds into a retirement account may not make sense. Furthermore, many retirees face an entirely different set of questions in order to minimize their tax bill.
Individual Retirement Account (IRA)
An Individual Retirement Account is a popular and smart way that many Americans save for retirement. One can contribute up to $5,500 per year ($6,500 if age 50 or more). There are three things to keep in mind when contributing to an IRA.
- IRAs have tax advantages;
- To contribute, one must adhere to certain rules; and
- For US expats that exclude foreign earned income, there is some complexity
There are two basic types of IRAs: traditional and Roth. With a traditional IRA, one receives a tax deduction in the year of the contribution. As a result, it is possible to lower the amount of taxes owed to the US government by contributing to a traditional IRA. The second tax advantage is that the assets in the IRA are allowed to grow year-after- year without being taxed (referred to as tax deferral). However, taxes are owed at the back end when one takes distributions, or cashes out of the IRA.
With a Roth IRA, the tax advantage works in the opposite direction. There is no upfront tax deduction in the year of the contribution. However, the assets in the IRA grow year-after-year without being taxed, and distributions are also tax-free.
For US expats, general suggestions for IRAs include:
–If utilizing the foreign earned income exclusion, find opportunities to create taxable
income (don’t exempt all the income), so that you are able to contribute to an IRA;
–If one’s income level is above the maximum foreign earned income exclusion amount,
definitely consider contributing to a traditional IRA; and
–If one has zero or very little taxable income, consider rolling over funds from a
traditional IRA to a Roth IRA. Depending on the amount, you may be able to make the
conversion without a tax liability – a great long-term tax strategy.
Individual circumstances should absolutely determine the exact approach one should take with respect to investment management decisions. When in doubt, speak to a credentialed tax and investment professional.
This article was written by John Ohe – CFA and IRS Enrolled Agent.
John works at Hola Expat, which provides tax services for Americans living
abroad. If you would like to submit a question, email info@holaexpat.com.
For information on various tax-related topics, visit: holaexpat.com.
