It's amazing how many investors ignore taxes when
making investment decisions.
I'm not suggesting that taxes should be the primary
factor in your investments. Many investors did that during the heyday of the
tax shelters and they ended up without any tax benefits and without any
investments either.
Investing is a game of numbers. The four most critical
numbers are
(1) the total yield or return on investment,
(2) the risk adjusted return,
(3) the applicable tax rate and
(4) the inflation rate.
Most conservative investments generate an after tax
return that is less than the rate of inflation. Thus, the real rate of return
after taxes is often negative.
Higher yielding investments don't help if you adjust
your average return for the risk element. As a general rule, the risk
adjusted rate of return on any investment is equal to the rate of return on a
low risk investment such as a short term government bond. Thus, higher yields
don't really solve the problem. There are exceptions to this general rule if
you adopt a system of asset allocation that can provide higher returns with
less risk.
There is little that can be done to solve the inflation
problem other than to engage in political action to "throw the rascals out".
Until we can replace the free spending politicians in Washington, there's not
much an individual investor can do about inflation. After many years of
inquiry into the real cause of inflation, I'm convinced that the real culprit
is federal deficit spending. We have been building up a huge debt with larger
and larger annual deficits. As those deficits are financed by new money
created by the Federal Reserve (monetizing the deficits), the result is
inflation. And there is nothing that will stop it until the politicians stop
spending more than the taxes they collect.
That leaves tax avoidance or deferral as the only
other way to achieve higher yields in inflation adjusted terms. With
informed tax planning, an investor can increase his or her inflation adjusted
real rate of return by 50% to 100%. In some cases where the current real rate
of return after taxes is negative, tax planning can change that to a positive
number. The "secret" is to understand the real power of compound interest -
adjusted for inflation. On this basis, tax deferred investing takes on an
entirely new perspective.
There are numerous tax breaks that are available to
investors.
Certain kinds of income that are derived from the use
of capital are income tax free. One example is tax free municipal bonds.
Another is cash value life insurance. A third is the imputed rental value of
a residence and the $250,000 per taxpayer exemption for gains on the sale of
a primary residence.
With the passage of the tax law in 2003, the maximum
rate of tax on long term capital gains and dividend income is 15%. These
changes will substantially alter the economic benefits of many other tax
arrangements for investors.
Other investments offer long term tax deferral with the
benefit of being able to reinvest the income without immediate tax. Examples
include an assortment of retirement savings plans, deferred annuity contracts
and U.S. savings bonds. Investments held by a charitable trust are also tax
deferred until the income is distributed to the beneficiary. If the stock in
a closely held corporation is sold to an employee stock ownership plan, the
proceeds may be reinvested by the owner of the business in an assortment of
other domestic stocks and bonds on a tax deferred basis. Certain kinds of
assets may be eligible for a tax deferred exchange, while others may be
eligible for the tax deferred installment sale treatment.
Some investments offer the potential for tax favored
treatment of any gain. Long term capital gains are now subject to a maximum
tax rate of 15% (28% for certain kinds of "collectibles"). For taxpayers in
the 15% income tax bracket, the maximum tax rate on long term gains is 5%.
The same rates apply to qualified dividend income.
Numerous kinds of investments such as growth oriented
common stocks, land and other tangible assets are eligible for the lower rate
on capital gains if they are held for more than one year.
When investments are gifted to lower tax bracket family
members, the recipient takes over the tax attributes of the donor. If a stock
is appreciated and has been held for more than a year, it would be eligible
for 15% maximum tax rate on capital gains. But -- but giving the stock to a
lower bracket dependent (such as a child who is going to college), the
dependent may be eligible for a 5% maximum tax rate on the same stock.
A more extensive discussion of the inter-action of the
rate of tax and the rate of inflation is included in
Risk Management for
Investors.
.jpg)
