It’s Not What You Make, It’s What You Keep

We all invest to make money, right?  Many investors watch the market on a regular basis to ensure their portfolio is moving in a positive direction. Although we know we have no control over the market, we still watch in hopes of getting that good feeling of progress towards our financial goals. While we can’t control the market, we can control our investment choices to some extent. 

Another area of limited control is the tax we pay on our investments. We have little say over what Congress does about tax law, because all we can seemingly do is vote or write our members of Congress. However, we have significant control over how we setup our investment accounts and how they’re taxed.  

For example, did you know you have very different tax rates that apply to your investments?  You have an ordinary income tax rate and also two lower tax rates that apply to your investments. They’re known as the qualified dividend tax rate and the long-term capital gain tax rate.  For purposes of this article, let’s call these lower rates your “investment” tax rates.  They can be quite different from your ordinary rate. For example, someone with the highest 37% ordinary income tax rate can have an investment tax rate of 20%. Someone with a 24% ordinary income tax rate can have an investment tax rate of 15%, and someone with a 12% ordinary income tax rate can have an investment tax rate of 0%!

As you can see, most of the time your ordinary income tax rate can be almost double your investment tax rate. Here’s the application for you: certain investment types are still taxed at the higher ordinary tax rates. Yet others are taxed at the lower investment tax rates, and income from municipal bonds are generally exempt from federal income taxes altogether. Annuities are always taxed at your higher ordinary income tax rates, but for many other investments, you only have to hold them for one year to obtain the preferred investment tax treatment. 

The issue is even more important as it relates to retirement accounts like 401ks and IRAs, as well as Health Savings Accounts. Some of these accounts give you an ordinary income tax break on the front end, some on the back end, and one even gives you a tax break on both ends!

That’s why it’s important to sit down with your tax advisor to determine how each investment is taxed and analyze potential opportunities to shift investments into lower tax situations. It can also be very helpful for retirees to analyze their retirement tax shelter accounts to determine the benefits of withdrawing from some before others. 

We can’t control the market, and we don’t have much control over Congress, but by having a better understanding of how your investments are taxed, you can be better prepared to keep more of what you make. 

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