Investing and Tax Considerations: Minimizing The Tax Burden On Investments

Investing and Tax Considerations

A hallmark of good investing is managing the tax implications.  Investing can be complicated and taxes are always complicated. It sure doesn’t make it any easier by putting them both together.  To help you keep as much of your investment earnings as possible, we will cover some of the basic tax considerations.

  • Tax efficiency is simply how much of an investment’s return still remains after all the tax obligations have been taken care of.

A good general rule to remember is that the more an investment’s return is dependent on income rather than an increase in share price, the worse the tax burden usually is, or the less tax efficient it is.

Taxable or Non-Taxable

Investment accounts are classified as either taxable or non-taxable. If an account is taxable, then the taxes must be paid on investment income in the same year in which it is received. This would include bank accounts, money market mutual funds, and your basic individual or joint investment account.

Non-taxable accounts are free from taxes as long as the money stays in the account. When you start taking money out, your tax liabilities kick in. This would include any type of retirement account, like your 401(k) and IRA.

  • A good rule to follow is to use your non-taxable accounts for the less efficient investments and the taxable accounts for the more efficient investments.

The Effect of Your Tax Bracket

If you’re going to invest with taxes in mind, be aware of your tax bracket. You must determine your marginal income tax bracket and also whether or not you’re subject to the alternative minimum tax. The higher your tax bracket, the more important it is to be in tax efficient investments.


Current Income versus Capital Gains

There are also differences between taxes on current income and taxes on capital gains. Any current income is usually taxed at your tax bracket rate. Capital gains are categorized as either short-term or long-term. Short-term investments are those held less than a year; long-term would be anything longer than a year. Typically, short-term gains are taxed as income and long-term gains are at the preferential rate.


Tax Treatment for Typical Investments

Consider these tax treatments for the investments you’re considering:

  • Dividends are normally taxed at a lower preferential rate. So dividends are likely to be a better for an investor in a higher tax bracket than for one in a lower bracket.
  • Bonds provide interest and are usually taxed at the marginal (income tax bracket) rate. This would not be a tax efficient investment for someone in a higher tax bracket.
  • The gains realized from stocks that are held for over a year and then sold would be taxed at the preferential rate.
  • Some investments with poor tax efficiency would include junk bonds and preferred stock. This is due to the high interest received and the high, fixed dividends that are received, respectively.
  • High tax efficiency investments would include stocks and municipal bonds. Municipal bonds are not taxed at the federal level and the yields are quite low. Stocks are typically held for more than a year, so the gains are taxed at the preferential rate. Both can be held in retirement accounts, which would make them even more tax efficient.

Minimizing the tax burden on investments is well within the reach of any investor, even beginners. Simply take a look at your marginal tax bracket and the preferential tax rate and make a plan. If your marginal tax rate is relatively low, you have a lot more flexibility. If it is high, then more planning will really pay off.