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What is Tax Efficiency?

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  • Written By: Alexis W.
  • Edited By: Heather Bailey
  • Last Modified Date: 30 November 2016
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Tax efficiency exists when an investor or individual pursues a course of action that minimizes his tax burden. The concept of tax efficiency exists in several main facets of business and personal finance. Tax efficiency is important when determining how to invest. It is also important when determining which business organizational structure to choose and when planning an estate and leaving money to heirs.

Tax efficiency in all contexts means making a choice of one item over another, on the basis that the chosen item will result in a lowered or reduced tax burden. In the investing context, for example, the most tax efficient investments are those that either allow a person to invest money pre-tax or those that allow a person to have his funds grow without being taxed. Within the United States, for example, a 401(k) plan and a traditional individual retirement account (IRA) allow individuals to invest money with pre-tax dollars, which means those individuals can deduct anything put into an IRA or 401(k) from their gross taxable income. A Roth IRA, on the other hand, is a type of investment in the United States wherein the investor invests with after-tax dollars but is not taxed on gains or withdrawals.

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In investing, it is up to the individual to determine which account type is most advantageous for his tax burden. For example, if a person anticipates being in a lower tax bracket at retirement when he begins to draw or take distributions from his IRA or 401(k), then a standard tax-deductible IRA would be his best bet. If a person believes he will be in a higher tax bracket at retirement, then he should consider a Roth IRA instead.

Tax efficiency is also an important concept in estate planning. The least tax efficient way for a person to inherit is through the intestacy process. This occurs when no will is left and the court distributes assets; all assets distributed are generally taxed by the receiver. A person who creates a trust, on the other hand, can achieve maximum tax relief and lower the taxable value of his estate dramatically by removing assets from the probate or intestacy process. Since the assets in an irrevocable trust do not pass directly from one owner to the other, but are instead owned by the trust, no tax burden may occur when a person inherits.

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