It’s near the end of the year, when every young (or old) man’s (or woman’s) thoughts turn to taxes.
For investors, there are several things to think about regarding taxes. We’ll talk here about one of the more significant ones.
Note: These comments are for educational purposes only. Before making any decision regarding taxes, you should get advice from a qualified tax professional who is familiar with the tax issues regarding trading and investing. If you need help along these lines, the OTA Tax Pros can assist.
With that in mind, here are some areas to think about.
Types of Returns Generated by Investments
Your investments should be in a diversified group of assets. Some of those assets generate returns in the form of cash flow – interest, dividends, rents and royalties. Examples include bank accounts, bonds, annuities and preferred stocks.
Other assets generate returns mainly from capital appreciation – increases in value, which you eventually realize by selling the assets at prices higher than your cost. Examples of these growth-oriented assets include common stocks and precious metals.
Some assets have the potential both for cash flow and for capital appreciation – dividend-paying common stocks, real estate and REITS are examples.
Each asset will have an expected total rate of return. In general, cash-flow-generating assets provide lower average rates of return than growth-type assets, while being much less variable in their returns from year to year.
You should have money allocated to several different assets in multiple categories, for the reasons discussed in earlier articles.
Tax Treatment of Various Investments
You probably have your various assets held in different accounts. Some of those accounts may have special tax treatment:
In the U.S., in a traditional Individual Retirement Account, income and gains are not taxed currently. The money is taxed eventually when you withdraw it out, and only to the extent that you withdraw it in a given year. Money in your employer’s 401(k), 403(b), 457 or TSP is also tax-deferred.
Annuities are tax-deferred, sort of, in that you are taxed on only part of the periodic annuity payments. This is because most of the dollars you receive represent repayments to you of your own principal. This is not a real tax deferral but appears like one.
In a Roth IRA, gains and income are completely tax-free. You paid tax on the contributions when you put them into the Roth and are not taxed again when you withdraw the funds.
So, our order of precedence should be to place the assets that you expect to have the highest return in a tax-free environment like a Roth IRA, if available; the next-highest in a tax-deferred mode like a traditional IRA or in stock funds within your 401(k), to the extent possible; and the balance in accounts that are fully taxed. In a few words: to the maximum extent that you are able, put capital that will earn the most where it will be taxed the least.
Example of Growth in a Tax Deferred vs. Non-Tax Deferred Investment
The following example helps illustrate the benefits of putting assets into a deferred-tax environment like a traditional IRA. It starts with a balance of $1,000 and an assumed annual pre-tax return of 5% annually, where the money is left to accumulate over a period of ten years, at which point the accumulated income is withdrawn.
It shows the difference in after-tax returns between two alternatives for the placement of this asset: a currently taxed account, where tax is paid on the income each year even though it is not withdrawn (no deferral); and a tax deferred account, where the gains are not taxed until they are withdrawn at the end of the ten years. Results are shown for various income tax rates. All examples make a very simple assumption, which is that the investor’s tax rate remains the same for the entire period. Your mileage will vary.
Example of the Benefit of Tax Deferral | ||||||
Annual Yield | 5% | |||||
End of Year | Balance if compounded | No-Deferral Annual Tax at Tax Rate Shown | ||||
0 | 1000 | 10% | 22% | 32% | 37% | |
1 | 1050 | |||||
2 | 1103 | $5.00 | $11.00 | $16.00 | $18.50 | |
3 | 1158 | $5.00 | $11.00 | $16.00 | $18.50 | |
4 | 1216 | $5.00 | $11.00 | $16.00 | $18.50 | |
5 | 1276 | $5.00 | $11.00 | $16.00 | $18.50 | |
6 | 1340 | $5.00 | $11.00 | $16.00 | $18.50 | |
7 | 1407 | $5.00 | $11.00 | $16.00 | $18.50 | |
8 | 1477 | $5.00 | $11.00 | $16.00 | $18.50 | |
9 | 1551 | $5.00 | $11.00 | $16.00 | $18.50 | |
10 | 1629 | 629 | $5.00 | $11.00 | $16.00 | $18.50 |
Ten-year Total Income without Deferral | 500 | 500 | 500 | 500 |
Ten-year Total Tax – no deferral | $50 | $110 | $160 | $185 |
Total after-tax income – no deferral | $450 | $390 | $340 | $315 |
Ten-year Total Tax – with deferral | $63 | $138 | $201 | $233 |
Total after-tax income – with deferral | $566 | $491 | $428 | $396 |
Percentage improvement from deferral | 25.78% | 25.78% | 25.78% | 25.78% |
The result of the tax deferral is that not paying the tax each year leaves more in the account to generate returns, so that the total amount of pre-tax income is higher – in the above case a total of $629 in pre-tax income instead of $500. Even though you do eventually pay tax on a higher amount, your after-tax income is still higher with the deferral. (This does not account for the time value of the tax savings, which would make the difference even higher). The higher your income tax rate, the more you save in total dollars. The percentage improvement in your after-tax return from the deferred account compared to the non-deferred account is the same no matter what the tax rate – you net over 25% more after-tax income.
For assets with higher rates of return, the benefit of the deferral is even greater. Below is the same example but with an 8% annual pre-tax return.
Annual Yield | 8% | |||||
End of Year | Balance if compounded | Deferred Income | No-Deferral Annual Tax at Tax Rate Shown | |||
10% | 22% | 32% | 37% | |||
0 | 1000 | |||||
1 | 1080 | $8.00 | $17.60 | $25.60 | $29.60 | |
2 | 1166 | $8.00 | $17.60 | $25.60 | $29.60 | |
3 | 1260 | $8.00 | $17.60 | $25.60 | $29.60 | |
4 | 1360 | $8.00 | $17.60 | $25.60 | $29.60 | |
5 | 1469 | $8.00 | $17.60 | $25.60 | $29.60 | |
6 | 1587 | $8.00 | $17.60 | $25.60 | $29.60 | |
7 | 1714 | $8.00 | $17.60 | $25.60 | $29.60 | |
8 | 1851 | $8.00 | $17.60 | $25.60 | $29.60 | |
9 | 1999 | $8.00 | $17.60 | $25.60 | $29.60 | |
10 | 2159 | 1159 | $8.00 | $17.60 | $25.60 | $29.60 |
Ten-year Total Income without Deferral | 800 | 800 | 800 | 800 |
Ten-year Total Tax – no deferral | $80 | $176 | $256 | $296 |
Total after-tax income – no deferral | $720 | $624 | $544 | $504 |
Ten-year Total Tax – with deferral | $116 | $255 | $371 | $429 |
Total after-tax income – with deferral | $1,043 | $904 | $788 | $730 |
Percentage improvement from deferral | 44.87% | 44.87% | 44.87% | 44.87% |
In this case, the benefit of the deferral is almost 45% more after-tax income.
I hope this has given you something to think about as to the deployment of your investment assets. There are many more tax-related matters to consider, but this one could be one of the most significant
Read the original article here - Tax Considerations for Investors
This content is intended to provide educational information only. This information should not be construed as individual or customized legal, tax, financial or investment services. As each individual's situation is unique, a qualified professional should be consulted before making legal, tax, financial and investment decisions. The educational information provided in this article does not comprise any course or a part of any course that may be used as an educational credit for any certification purpose and will not prepare any User to be accredited for any licenses in any industry and will not prepare any User to get a job. Reproduced by permission from OTAcademy.com click here for Terms of Use: https://www.otacademy.com/about/terms
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