What You Need to Know About Taxes Before You Invest Your Money
When it comes to investment decisions, taxes should never be the deciding factor. But a smart investor looks to minimize taxes wherever possible.
The following is a refresher on some basic tax and investing facts:
- Generally, taxpayers may hold their investments in two types of accounts — taxable accounts, such as brokerage accounts, and tax-deferred accounts, such as an individual retirement account or a 401(k).
- Bond interest is generally taxed at ordinary rates unless the investment is held in a tax-deferred account. The ordinary rates are 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. A major exception is municipal bond interest, which is generally tax exempt.
- Taxable capital gains are subject to lower rates if the gains are considered “long term” (generally, securities were held longer than one year). For most taxpayers, the long-term capital gains rate is 15%. For those in the 39.6% ordinary tax bracket, the rate is 20%; for those in the 10% or 15% brackets, the rate is 0% (gains are not taxed).
- The same long-term capital gains rates apply to qualified dividends.
- Capital gains on securities held one year or less (“short term”) are taxed at ordinary rates.
- High-income investors may have to pay an additional 3.8% net investment income tax.
- Withdrawals from tax-deferred accounts are generally taxed at ordinary rates, even if the withdrawn funds represent long-term capital gains or qualified dividends.
There are several tax strategies you can use to minimize taxes on investments.
Maximize retirement contributions to tax-deferred accounts. By making tax-deductible or pretax contributions to IRAs or employer-sponsored retirement plan accounts, you delay the payment of income taxes. Investing the tax savings can boost returns.
Minimize turnover. Constant trading of securities within a taxable account turns unrealized (“paper”) gains and losses into realized gains and losses that are reportable for tax purposes. One way to minimize turnover is to avoid frequent trading. Another is to avoid mutual funds with high turnover ratios. Certain funds trade more frequently than others, and at the end of the year, they may distribute more taxable capital gains to their shareholders. Passively managed index funds trade relatively infrequently and tend to have lower tax costs.
Compare yields. Before choosing tax-exempt bonds, calculate whether they make sense for you. To determine how the yield on a taxable bond compares to the yield on a tax-exempt bond, subtract your marginal tax rate from one and divide the result into the yield on the tax-exempt bond.
Example. Laura is in the 33% federal income-tax bracket. She wants to know how much a taxable corporate bond would have to yield to match the 1.75% yield offered on a tax-exempt bond. She subtracts .33 from one and divides the result (.67) into 1.75% to arrive at 2.6%. Therefore, a taxable bond at that rate or above generally would be preferable.
Generally, the yield differentials between taxable and tax-exempt bonds make tax-exempts more suitable for higher bracket taxpayers.
Asset allocation. Because higher tax rates point toward tax deferral, a logical strategy is placing assets that are taxed at relatively low rates in taxable accounts and assets taxed at higher rates in tax-deferred accounts. Give us a call today to learn more about the tax consequences of investing.