Taxpayers are always looking for ways to accomplish the wealth trifecta - preserve principal, generate income, and minimize taxes. Yet accomplishing this feat is very challenging due to a number of external factors. In order to preserve principal, investors must often sacrifice higher returns for less risky investments, which reduces income. Riskier investments have the potential to generate higher returns (income), but they also present the risk of loss of capital. Furthermore, investments that generate income subject the investor to a higher tax rate. As you can see, it's easy to find investments that meet 2 out of 3 of these criteria, but winning the trifecta is much more difficult. Following are some alternatives for taxpayers looking for tax-efficient investments.
Municipal bonds
Municipal bonds (muni's) are tax-efficient in that the income they generate is typically not taxable at the Federal level and, if planned correctly, at the state level. Muni's are bond issues for municipalities such as cities, counties or school districts. Muni's, like all bonds, are sold at a premium or a discount depending on the bond's yield at the time of sale.
Interest on municipal bonds is always tax-exempt at the Federal level. Each state is different, but in Arkansas, all interest earned on Arkansas municipal bonds is tax-exempt to Arkansas. For example, an Arkansas taxpayer with municipal bond interest from school districts in Arkansas and Texas will only pay Arkansas tax on the interest from the Texas school districts.
Beware that tax-exempt income is a preference item for the alternative minimum tax. Investors considering substantial investments in tax-exempt bonds should consult their tax adviser to verify that the interest will not subject them to the AMT.
Master limited partnerships
Master limited partnerships (MLPs) have gained popularity in recent years for their favorable tax treatment. Investors enter into MLPs as a partner. During the year, they receive distributions from the partnership that are not taxable. Then, at the end of the year, the investor receives a Form K-1 reporting their share of income and losses.
Although it is possible for the K-1 to report income to the partner, due to non-cash expense items the distributions typically exceed the amount of income on the K-1. The downside to owning units in an MLP is that, upon sale, a portion of the gain (if any) is reported as ordinary income. See additional information regarding investing in MLPs in a previous article regarding owning MLPs in a retirement account.
Practical considerations
Tax-efficient investing is best suited for investors that desire to preserve principal in their investments and also do not have many deductions to offset their taxable income. A young taxpayer with children at home, dependent care expenses and a mortgage can afford to generate more investment income because their effective tax rate will be lower as a result of their deductions. However, a taxpayer with no children and few deductions will benefit more from tax-efficient investing.