Understand Taxes And Investing

Silent Partner - The IRS

Often I refer to the IRS as your "silent partner." They share in a portion of your income and profits via taxes, and they also maintain the ability to change the amount they take.

This is not the type of silent partner I wish to do much business with, but in most cases you are required to pay taxes.

This article outlines the important factors an individual should know about taxes when it comes to investing.

Having proper tax planning can mean the difference between a successful investor and an unsuccessful one.

I'm not a tax adviser, and I like to keep it simple. So with that in mind this list is a high level overview with links provided for further detail.

What Should You Know?

• We use a progressive tax system. There are several different tax rates that may apply to your income. This is misunderstood by a majority of Americans.

• Marginal Tax brackets is the highest rate you will pay on your income. For example a 22% marginal tax bracket means that you will pay $0.22 cents on $1.00 earned going forward until reaching the next bracket.

• Be aware of your marginal tax bracket when looking into investment options.

• Utilize an Tax Equivalent Yield calculator to compare tax-free returns of municipal bonds to taxable returns. The higher your tax bracket the more advantageous tax-free return becomes.

Although the tax rate is from 2017, this is still a great comparison of tax equivalent yield.

3 Tax Buckets

• Taxable accounts - Savings/checking, non-qualified investment

• Tax-Deferred Accounts - Traditional IRA's 401(k)s, 403(b)s, other traditional qualified plans

• Tax-Advantaged Accounts - Includes Roth IRA, other Qualified Roth Plans (Roth 401(k) Roth 403(b)), 529s, HSAs, Muni Bonds, Series EE Savings Bonds, and Life Insurance Cash Value. Also known as Tax Free accounts if used properly.

How These Buckets Are Taxed

Phase 1) Accumulation - Saving

• Taxable Account - pays taxes on all growth within a year every year... Not optimal for tax purposes. Normally suitable for emergency funds. Most liquid normally.

• Tax-Deferred Accounts - No taxes paid on the growth of the account. Used to reduce income now via tax deductions.

• Tax-Advantaged "Free" Accounts - No taxes paid on the growth of the account. No deductions allowed (unless HSA).

Phase 2) Income - Spending

• Taxable Account - taxes paid on any gains or income from selling in the year sold.

• Tax-Deferred Accounts - taxes paid on any income distributed out of the account. Required distributions start at 70 1/2. May be pushed to 72 with the SECURE Act.

• Tax-Advantaged "Free" Accounts - No taxes paid on any income distributions or gains. No required minimum distributions. Life insurance cash values can be drawn down to cost basis then utilize a loan strategy to maintain tax free income.

Phase 3) Death (or Distribution)

• Taxable Account - If there is not a step-up in basis upon death, it is normally taxable to the beneficiary when sold for a gain.

• Tax-Deferred Account - Account is fully taxable to inheritor, and if beneficiary is not a spouse distributions are required to be taken by the inheritor.

• Tax-Advantaged "Free" Accounts - Pass completely tax free to the beneficiary and there are no taxes due when selling the asset. Life Insurance plans offer a tax-free death benefit to the beneficiary.

With the TCJA of 2017 decreasing the tax brackets to all time lows, utilizing tax-free accounts may be your best option. For more information see How To Pay 0% Taxes In Retirement.

Taxes should always be considered when investing. This is why it is often best practice to have a CPA as well as a financial adviser working together on your team.

Finding a Trusted Financial Adviser to review your investments for tax-efficiency may save you loads over time in taxes!

Thank you for your time!

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Also See: Easy Steps To Setting Up Your 401(k)

Also See: Options For Handling Your Old Retirement Accounts (401k, 403b, 401a, Employer Plans, Etc.)