When it comes to investing, we often focus primarily on returns, and it’s easy to neglect the true return, which comes after we pay taxes. As investors, there are typically three ways we pay taxes – on capital gains, dividends and interest. Understanding the differences and using the right strategies can help you increase your after-tax returns.
Capital gains taxes are paid when we sell an investment for a gain. We can also be subject to capital gains taxes due to trading activity within mutual funds. Using mutual funds with low turnover ratios, or investing in more tax efficient ETF’s, can help minimize this tax liability.
Dividends can be helpful for supplementing retirement income, but they can be taxed as high as your income tax rate. Dividends are paid out as one of two types, qualified or non-qualified.
Qualified dividends are taxed at lower rates but must meet specific IRS criteria. Paying attention to the types of dividends and meeting the requirements can help lower your tax bill.
Finally, interest from money market funds, savings, CD’s, bonds, mutual funds, and ETF’s is typically taxed at your ordinary income rate. When you are comparing an investment in a taxable to a tax-exempt investment, it’s critical to compare the after-tax return.
Let’s look at a hypothetical example for someone in the 32% tax bracket comparing a 4% taxable bond versus a 3% tax free bond:
In this situation, a taxable bond paying 4% interest is equivalent to a tax-exempt bond paying 2.72%. If you weren’t looking at the after-tax impacts, you might select the taxable bond because it’s paying a higher pre-tax interest rate. But you’ll want to determine which investment vehicle is most appropriate based on what gives you the highest after-tax return and is aligned with your overall investment objectives.
Making smart tax moves within your investments can go a long way to improving your after-tax return and help you keep more of your hard-earned money.
