- Inflation, taxes and transaction costs are often overlooked, but can take a substantial bite out of your long-term wealth accumulation goals.
- When it comes to paying taxes, it seems natural to defer doing so. But, everyone’s circumstances are different and things change as you go through life.
- Tax planning is tricky. The rules are complex and change frequently. Review your situation at least once every year with trusted advisors.
*** Click for more on planning and gifting stock between generations.
A wise sage once told me, “When the government owes you taxes, now is better than later. But, if you owe the government taxes, later is better than now.”
Most of the time that approach works really well. Now let’s talk about your overall return. If you are earning 6 to 7 percent on your investments on an annual basis, that’s not bad. But, there are three factors that take away from your long-term returns:
- It’s been averaging 3 percent annually over the past half century.
- That could take another 1 to 3 percent out of your (6 to 7 percent) annual return. That’s because many of you are in high brackets, paying 40 to 45 percent a year in state and federal taxes.
- Transaction costs. Those are broker commissions, mutual fund investment charges, investment management fees, etc. Those costs are coming down but they still effect your return.
Let’s talk about three forms of ownership from a tax standpoint.
- Taxable investments. Whether you own the assets personally, jointly with your spouse or in a revocable trust, you must pay taxes on your income and gains as you go along.
- Tax-deferred. IRAs, 401(k)s and other types of retirement accounts enable you to defer paying tax on your earnings until you withdraw the money later in life, presumably when you’re retired or otherwise in a lower tax bracket.
- Tax-free. This includes municipal bonds and other investments you can make that are not taxed by the federal government.
As most of you know, we have a progressive tax structure in this country—the more you earn, the higher the percentage of income you must pay to the government. Knowing what kind of income you have (ordinary, short- or long-term capital gains, etc.) and planning around that can make a difference.
So here are three key planning considerations:
- What’s the financial structure? Taxable, tax-deferred or something else? You want to defer wherever possible.
- What’s the investment vehicle? Does it generate interest and dividends? Are the dividends qualified (i.e., taxed at the lower long-term capital gains rate) or non-qualified dividends (i.e., taxed at the same rate as your normal income)? Are the gains short term (held less than one year) or long term? Long-term gains are generally taxed at much lower rates.
- Where are you taking your distributions from? If you take distributions from a qualified retirement plan, they’re going to be fully taxed (as opposed to when you make withdrawals from personal accounts).
Beyond these considerations, there are plenty of other nuances that come into play. Back in December, I did a post on planning/gifting stock between generations and explained how young people in the zero, 10 or 15 percent brackets pay no tax on capital gains, while whoever gifted the stock might have paid the highest rates.
State and federal tax laws change every year, so you need to review your situation often and adjust as needed. For instance, here in Illinois, retirement income isn’t currently taxed, but Governor Rauner may be negotiating with the Illinois Congress to change that. This kind of thing rears its ugly head periodically and we’ll keep you up to date.
Until next time, enjoy. Gary
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