What is Tax Efficiency?

Tax efficiency involves making investing choices that reduce one's tax bill.

How Does Tax Efficiency Work?

For example, let's assume that John owns 100 shares of Company XYZ stock, which he bought six months ago for $5 a share. John also owns 100 shares of Company ABC stock, which he bought for $5 a share two years ago.

Both stocks increase to $10 per share, meaning John now has paper profits in both investments. But if he wants to cash out one of the positions, which one is more tax efficient?

Let's assume the short-term capital gains tax is 25% (for stocks held less than one year) and the long-term capital gains tax is 15% (for stocks held for longer than one year).

Consider the following calculations:

John sells Company XYZ shares: 100 shares x $10 per share = $1,000
Capital gain on the investment = $1,000 - $500 original purchase price = $500
Short-term capital gains tax = $500 * 25% = $125

John sells Company ABC shares: 100 shares x $10 per share = $1,000
Capital gain on the investment = $1,000 - $500 original purchase price = $500
Long-term capital gains tax = $500 * 15% = $75

As you can see, the Company ABC shares are more tax efficient because they have been held longer and thus are subject to a lower tax rate.

Why Does Tax Efficiency Matter?

In the investing world, tax efficiency is a big deal. In some cases, such as the example above, the length of time an investment is held can make a difference in a portfolio's tax efficiency. In other cases, certain investments (such as municipal bonds) are simply not subject to certain taxes, making them tax efficient as well. In general, tax efficiency is as much a matter of strategy as it is a matter of tax brackets.

Investors in high tax brackets are often more interested in tax-efficient investing because the potential savings are more significant. However, every investor's portfolio should be as tax efficient as possible. Not only do taxes lower an investor's returns by reducing the amount of cash he or she has to reinvest, but they can also create considerable liquidity barriers for investors who might face huge tax penalties for accessing their own money at the wrong time.