Tax-Favored Investments

    

Allocating capital well involves understanding income tax rules; and you'll make better investment decision about where to place your capital, the better you understand tax on investments.  Different rates of tax are charged against varying types of income. The least favorable rate of tax is the ordinary rate. The ordinary rate is the highest rate of tax that an individual will pay; the actual amount is based on a sliding scale (a progressive rate) that rises as earned income rises. For example, the first $8,025 of a single taxpayers taxable income is taxed at just 10%. However, that same taxpayer must pay a rate of 33% on taxable income that is between $164,550 and $357,700; plus he or she must pay an additional $40,052.25 to account for all the tax due on the income below $164,550.¹ Taxes play a very negative role in the pursuit of wealth; the combination of paying the ordinary tax rate and enduring rampant inflation is a lethal financial mixture.

Ordinary Rate for Earned Income

The ordinary rate applies to all earned income. Whether you work full-time or part-time and one job or three, all income earned from a job (wages, salaries, commissions, bonuses, tips, etc.) is taxed at the ordinary rate.

Ordinary Rate for Certain Types of Investments

The ordinary tax rate is also the rate charged against interest that is earned on most investments. For example, interest earned on U.S. savings bonds, corporate bonds, and most bank products, such as savings accounts, checking accounts, and certificates of deposit is tax at the ordinary rate. People who work two jobs, and have both a checking account that pays interest and a savings account, will pay the highest rate of tax on all earned and investment income.

Favored Tax Rates

Certain types of investments receive favored tax rates; and of those that receive some favor in the tax code, the tax incentive comes in multiple forms. Specifically, tax favored incentives fall into different categories; among those categories are those that relate to the timing of taxation, the rate of taxation, and the jurisdiction to which the tax is owed.

Timing of Taxation

If taxes on investment income can be deferred from payment in the current tax year, then that particular income is considered tax favored. For example, the 401k retirement plan allows individuals to defer the timing of income tax on that portion of current income that is contributed to a 401k account, and also on all investment gains that arise from those contributions. The deferment lasts until the person begins voluntarily taking qualified withdrawals from the account after passing the age of 59.5, or after a person turns 70.5, whether the distributions are wanted or not. Notably, there is no tax incentive as to the rate of tax but rather the appeal of the 401k is in the timing of when tax is due.

Reduced Rate of Tax

If a taxpayer is charged any rate of tax less than the ordinary rate, then the investment income is considered "tax favored".

Capital Rate for Specific Investments

• An example of a reduced rate is the capital gains rate; if a taxpayer sells a capital asset, like stock (or shares of a mutual fund), after holding it more than one year, then the maximum rate of tax is 15% on that gain. . . even though the individuals ordinary rate may have been as high as 35%. What you see is that, depending on your earned income level, and therefore their ordinary rate of tax, the reduced rate has the potential to cut some tax bills on capital gains by more than 50%.

Capital Rate for Qualified Dividends

• Many companies pay quarterly cash dividends to stockholders (shareholders). Most taxpayers in most circumstances will be able to claim the "qualified rate" for ordinary stock dividends (including those earned in a mutual fund). The qualified dividend rate is a maximum of 15%, if a taxpayer otherwise falls into the 25% marginal tax bracket (follow the hyperlink to footnote 1); and the rate is only 5%, if the taxpayers ordinary tax rate is less than 25%.

Jurisdiction-based Tax Relief

Another type of tax incentive lies within governmental jurisdictions.

U.S. Savings Bond Interest Exempt from State Income Tax

• Even though U.S. savings bond interest is taxable at the ordinary rate, tax can be indefinitely deferred, as no tax is due until the bond is redeemed. Additionally, tax will be due at the federal level when the bond is cashed (redeemed); however, interest earned on the federal savings bond is fully exempt from state income taxes.

Municipal Bond Interest Exempt from Taxation

• States and their political subdivisions (cities, counties, municipalities) may issue bonds. Municipal bonds are issued (sold) to the public in order to raise money to public projects. As the project earns revenue in the future, some of that revenue is used to pay bondholders interest. And Congress has put a major tax incentive in place: municipal bond interest is exempt (not merely deferred) from federal income tax. And if the taxpayer is a resident of the same state that issues the municipal bond, then the interest is also exempt from state income tax.

• As an example, the state of Illinois may issue general revenue bonds, so as to expand and improve state parks throughout all of Illinois. Residents of Chicago (and other places in Illinois) who purchase these bonds will be able to receive all interest completely tax free. This is jurisdiction-based tax relief.

Armed with the knowledge that not all investment income is treated equal, some people will choose to diversify the tax ramifications of their holdings. They can do this by holding stocks and bonds for many, many years (no tax due until the asset is sold); receive very low taxation (max. of 15%) on qualified dividends generated by stocks and mutual funds; invest earnings into the 401k and similar tax favored retirement plans; hold U.S. savings bonds for many years (tax on interest may be indefinitely deferred); and purchase municipal bonds in order to receive tax free interest. The key point to understand is that everyone needs emergency money (several months of total living expenses) stashed away in a savings account; however, bank products and income earned from a job generate the least favorable income that exists. Contributions to Qualified Retirement Accounts and the purchase of Capital assets, such as stocks, bonds, and mutual funds provide much more favorable investment choices for those who want to skimp on taxes.

 

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Notes:

1. http://taxes.about.com/od/2008taxes/qt/2008_tax_rates.htm