Ignoring the Impact of Taxes

Here’s a quick question for you – a 5% return beats a 3% return, right? Not always.

If the 5% return was from a taxable bond and the 3% came from tax-free municipal bonds, then the situation changes. Why is that?A taxable bond has to pay Federal and State income taxes in the year it’s received, while a tax-free bond (municipal bond) is tax-exempt at the Federal level and may be at the State and local level as well if those bonds were issued by the state in which you live.

For example, let’s say you received $10,000 of interest over the past year. If the interest was from a tax-free municipal bond issued in your state, you likely won’t have to pay any Federal or State taxes on that amount. You may have to pay local and city taxes depending on where you live but generally Federal and State and are the two big ones.

Now let’s says you received $10,000 from a taxable bond instead. The interest would be taxed as ordinary income and you would have to pay Federal, State, and local taxes. If your marginal tax rate is 22% than your after-tax amount would be $7,800. That’s a $2,200 difference between your after-tax return and your return from a municipal bond!

When you review your investments, one key rule to keep in mind is that you should always look at the after-tax return of an investment.

The tax impact of your Fixed income investment is only 1 tax consideration to keep in mind. You need to keep in mind other tax implications of your investments like when you…

  • Buy or sell investments
  • Develop a financial strategy
  • Discuss your estate or philanthropic plans, or
  • Give gifts

Remember that the federal government taxes investment income like dividends, interest, and income from real estate, as well as capital gains. Which is why it’s critical to structure your investments in a tax efficient way.

The chart you will see in the video shows you roughly how much money you’re paying into taxes as a proportion of your income. As your incomes increase, so do your tax liabilities.

If you looked at the chart and you’re concerned about how taxes impact your financial plan, be sure to discuss these issues with your financial advisor.

What’s the first step you should take after watching this video? Ask your advisor what they’re doing to reduce your tax liability.