Making Tax-wise Investments
Tax considerations are not, and should never be, the be-all and end-all of investment
decisions. The choice of assets in which to invest, and the way in which you apportion
your portfolio among them, almost certainly will prove to be far more important
to your ultimate results than the tax rate that you pay on your portfolio’s earnings.
However, that said, when you make a decision on where to invest your money, understanding
if, how or when your investments are taxed is important.
Here’s a quick review of some of the pertinent rules:
Taxable investments. Regular income tax rates currently range from 10% to
35%, but certain income from your investments receives special treatment. For instance,
most longterm capital gain is taxed at a maximum 15%. Qualified dividend income
also is taxed at a maximum of 15%. Are stocks, then, more appealing as income-producing
investments? Treasury bonds and notes and interest income are taxed at regular rates.
But there’s the risk factor to consider: A bond held to maturity should pay back
your principal. Investing in stocks carries no such assurance.
Tax-exempt investments. Tax-exempt municipal bonds yield a lower return than
taxable investments. Investing in munis will make sense only when the income from
the lower yield will provide you with more income than the after-tax return that
you would receive from a taxable investment. State taxes need to be factored in
as well. Munis issued in your home state are likely to escape taxation. The combination
of escaping both federal and state income tax may make these bonds an appropriate
Tax-deferred investments. Your contributions to a company retirement plan
or an IRA may be tax deferred, and the income from the investments may be tax deferred
as well. With your investment income unhindered by tax, your account can grow significantly
in comparison with your taxable investments. But tax deferred is not tax exempt.
Withdrawals become mandatory eventually and, in most cases, will be taxed at ordinary
income tax rates. The 15% long-term capital gain and dividend income rates are unavailable,
and, in the worst case scenario, return that would have been taxed at 15% is taxed
at 35%. And, of course, tax rates are not set in stone. What is 35% now could be
even higher when it comes time to take your money out of a tax-deferred plan.
The impact of taxes on a $10,000 investment
The following table illustrates the potential impact of taxes when $10,000 is placed
in taxable, tax-free and tax-deferred investments.* We’ve made the following assumptions:
You are eligible to receive a $10,000 bonus from your employer. A federal income
tax rate of 15% (on your long-term capital gain and dividends) will be applied if
you invest the bonus in stocks; a 35% rate if you invest in taxable bonds. No tax
will be paid if you contribute the money to your company retirement plan account.
The taxable stocks, bonds and company plan investments each earn 7% a year; tax-exempt
bonds earn 5% a year. (These returns are hypothetical and not based upon a particular
investment.) All earnings are reinvested.
How a $10,000 Bonus grows if you:
Initial Investment (after tax, if applicable)
What you have after 10 years
What you have after 20 years
Put it in stocks
Put it in taxable bonds
Put it in tax exempts
Put it into your company retirement plan
*No Social Security/Medicare tax has been factored into these numbers.
**Tax must be paid on withdrawals from a tax-deferred retirement plan. Assuming
that you still are paying tax at the maximum 35% rate, what you would receive after
tax after 20 years would be: $25,153. If you are in a lower bracket, say 28%, you
would net $27,862.