Just like wealth inequality, different asset classes have tax inequality. That is to say, different asset classes are taxed at different rates depending on what they are and how long they are held. As investors, we want to maximize our returns. Limiting the amount of taxes we pay on our returns is one way of doing so.
That’s why tax efficient investing is so important. If you are not investing tax efficiently, you are basically giving away your hard earned money to the government. However, in order to understand tax efficient investing, we need to first learn how investment income is taxed.
Ordinary Income & Short Term Capital Gains
Ordinary income and short term capital gains are taxed at your marginal rate. That means that you will be paying taxes on your income equivalent to your highest tax bracket. You will be taxed at your marginal rate on the following:
- Short-term capital gains
- Most bond and interest income
- Unqualified Dividends
Any asset class can be sold to experience a short-term capital gain. All you need to do is find a buyer that is willing to pay you more than your original purchase price. A capital gain is considered short-term if the holding period (i.e. the time that you have owned the asset) is less than a year.
Bond income is any interest that you obtain from issuing debt. Interest income describes any interest you earn on your cash, be in from a bank or from issuing a loan.
Finally, we have unqualified dividends, which are essentially cash payments for owning a shares of a company (typically dividends that are received from a non-US company or held for less than 60 days is considered unqualified).
Long Term Capital Gains & Qualified Dividends
Long term capital gains and qualified dividends are taxed at special rates that depend on your marginal tax bracket. The special rates are split into 3 different brackets, 0%, 15% and 20%. The long term gains bracket that you fall under is determined by your marginal tax bracket. Take a look at the table below for the correlation between the two rates:
|Marginal Tax Rate||Long Term Gains Rate|
As you can clearly see, you want to be taxed at the long term rate over the short term rate, as your tax liability is nearly cut in half! Let’s quickly go over the conditions for long term gains and qualified dividends.
How do I tell if I will be taxed at the long term capital gains rate?
Typically, if you hold an asset for a year or longer, any profit that you receive upon its sale will be taxed at the long term rate. For example, if you bought $100,000 worth stock and later sold it for $200,000 1 year after buying it, your profit of $100,000 ($200K, your selling price, – $100K, your cost basis) will be taxed at your respective long term gains rate.
How do I discern a qualified dividend?
There are plenty of rules that determine if a dividend is qualified or unqualified, but you can usually tell with a general rule of thumb: if the stock is a US company and you have held it 60 days or more, it is probably qualified. A notable exception would include real estate investment trusts, or REITs. Any dividend income obtained from REITs is taxed at your marginal rate.
Investments with limited tax liability
There are subsets of asset classes that get special tax treatment. Typically, the special tax treatment involves either paying less taxes, or deferring the tax liability to a future date.
Local Municipal Bonds
Municipal bonds are a subset of bonds that are used to fund public works for cities. Basically, you purchase a bond from a city, and then the city will pay you back interest on the bond. After some time, you will get your original investment back. Federally speaking, municipal bonds are not taxed. In addition, if you buy a municipal bond from the state of your residence, the bond interest is also immune to state taxes. Municipal bonds, if invested in locally, can be 100% free from taxes.
Inflation bonds (I-bond) are very unique (when compared to other bonds). They are like a hybrid between a bond and a savings account. Any interest earned on an I-bond is deposited into the value of the I-bond.
Like local municipal bonds, inflation bonds are tax free at the state level. However, what makes them especially interesting is that they defer taxes at the federal level. All interest gained on an I-bond is taxable by the federal government – however, you do not need to pay taxes on the interest that you get from your I-bond until you redeem it for cash. Basically, I-bonds push tax liability to the future and allow you to make the most of the interest that you do receive by having it automatically reinvested into the I-bond.
The Roth IRA – Zero Tax Liability
Another factor that determines the tax treatment of your assets is the financial vehicle that you choose to wrap them around. In general, if you invest using a regular brokerage account, you pay taxes on your investments(either the long term or short term rates). However, you can also use tax-advantaged accounts such as a Roth IRA to further limit your tax liability. Think of the Roth IRA as a magic blanket that you can wrap around your assets. Everything inside of the Roth IRA is immune to taxation. As a result, you can strategically place your investments in different vehicles to limit the amount of tax that you pay.
Strategy for tax efficient investing
The basic strategy for tax efficient investing involves the following principal: Place heavily taxed investments into tax-advantaged financial vehicles and place lightly taxed investments into regular accounts.
Let’s further explain this through an example. We are going to make a bond portfolio and we can place our bonds into two different accounts, a Roth IRA and a regular brokerage. We have the following bonds:
- A corporate bond (taxed at our marginal bracket)
- A local municipal bond (not taxed at all)
In order to optimize our asset allocation, we want to place our heavily taxed assets into our Roth IRA. This means that we should place as many of our corporate bonds as possible inside of the Roth IRA. Doing so will lessen the taxes paid on the corporate bonds interest. Then, we want to place our lightly taxed investments into our brokerage account. Thus, we need to put the municipal bond into our taxable brokerage account.
Assuming that the municipal bond is local, this asset allocation can result in us paying zero taxes!
Ultimately, it’s your choice as an investor as to whether or not you want to invest tax-efficiently. Investing tax-efficiently isn’t difficult by any means, it simply requires some forethought and planning. As long as you consider the basic tax rules tied to your assets and think logically about what financial vehicle to place them, you can easily become a tax efficient investor.
About the Author: Akash Sky teaches people about investing using intuitive graphics and simple, plain English over at akashsky.com.