Key Points

  • Tax planning is not just about figuring out how much to pay the government, it’s also about ensuring that your investment plan is tax efficient based upon your short-term and long-term goals.
  • Investments typically generate income from three different sources: interest, dividends, and capital gains; and each source is taxed differently.
  • These differences should be taken into consideration when forming an investment plan, as federal taxes can range from 0% to upwards of 37%.

I Am Not a CPA

Most people only think about taxes once a year. Essentially when tax season comes around, we jump into gear; get all of our paperwork together; and either spend a few days typing in numbers into our tax preparation software tools or going back and forth with our CPAs. And then we forget about taxes for another year. Out of sight, out of mind.

However, when it comes to forming a well-rounded investment plan, there are many financial incentives that involve taxes out there that should be taken into consideration. Let’s cover the basics in this post, and we’ll dig into some important things to watch out for over the course of this series. You’ll want to be aware of these incentives because if you fail to take advantage of them in a given year, there’s not much you can do; that is until next year. But wait too long, and you’ll have missed out on considerable opportunity to enhance your long-term wealth. So, to make sure your taxes are done right, be sure to consult your tax professional; but to make sure your investments are tax efficient, it also makes sense to reach out to your financial professional.

Back to Basics

When it comes to investments there a few key ways that most individuals earn income. We touched on this in the past (LINK), but let’s dig deeper this time.

First, there’s interest. These are payments that typically represent some percentage of an investment’s cash value that is paid out at regular intervals. For example, a typical savings account will pay out interest each month based upon the average cash balance of the account over the previous month. Alternatively, a bond may pay out a few percent of the principle (the amount initially invested in the bond) every six months. When it comes to taxes, the U.S. Government typically taxes interest based upon an individual’s marginal tax rate. Here’s the marginal tax rate schedule for 2019, which ranges from 10% to a high of 37%.

Then there’s dividends. These are payments obtained from holding equity in a company (either private or public). Often when a company shows a profit, a certain percentage of this profit can be distributed to shareholders in the form of a dividend payment. When it comes to taxes, dividends fall into two buckets; ordinary (higher taxes) and qualified (lower taxes). Ordinary dividends are taxed at the marginal tax rate schedule mentioned above. Qualified dividends are taxed at the long-term capital gains tax rate (discussed below), which ranges from 0% to 20%.

Next there are capital gains. When you sell an investment and post a gain, you have this type of tax to worry about. If you have had the investment for over a year, you pay the long-term capital gains rate, which for most people will be 15%. However, if you sell in less than a year then you will pay the marginal tax rate based upon the schedule mentioned above.

Of course, these are just federal taxes. There’s also state and local taxes to consider, and given the myriad of complexities with taxes in general, your specific situation may vary depending on your unique circumstances.

What Does This All Mean?

In order to grow your wealth as efficiently as possible, you will want to of course pay as little in taxes as possible. Not too hard to figure out, right? There a few key ways to accomplish this. First, all things being equal, you’ll want to pay lower taxes than higher taxes. So, based upon the different types of income mentioned above, it makes more sense to earn income through qualified dividends and long-term capital gains than from other sources. Second, it’s better to delay the payments of taxes for as long as possible. Third, if there are any tax advantaged programs offered by the government, these should be given first priority.

In the next post of this series, we’ll look at just how great an impact one can have by paying a low tax rate versus a high tax rate. You may be surprised to learn just how significant this difference can make over time, but check out Part 2 of this series for more.