Today we are tackling tax-efficient investing.
We all know a fast track to unhappiness is trying to control things we have zero control over.
And we all love to ignore this and continue to try to control things we have zero control over (I am a pro at this).
If you're a business owner in your first few years, you probably understand this stress.
We don't have direct control over revenue.
We have to focus on the inputs: more leads, higher conversions, pricing, etc.
It's the same with money.
We can't control investment performance.
We have to focus on the inputs: savings rate, low-cost investments, taxes.
Yes, taxes we have some control over.
And ignoring taxes is one of the most common investing mistakes I see.
So, today we're diving into Part 1 of tax-efficient investing.
First, you need to understand how your investments are taxed.
1) Ordinary income tax
Your salary, tips, and commission are all taxed this way.
The interest from savings accounts and bonds are also taxed as ordinary income.
The 2023 Federal Ordinary Income Tax Table:
We also have:
2) Capital gains tax
We deal with capital gains tax with your investments.
Your qualified dividends and gains from selling investments are taxed this way.
Capital gains are taxed at a better rate than ordinary income tax (see table below) but only if it’s a long-term capital gain.
If you sell an asset you held for 1 year or less, it will be taxed as a short-term capital gain.
Short-term capital gains are taxed at the same rate as ordinary income tax.
If you hold the asset for more than 1 year, it will be taxed as a long-term capital gain.
Long-term capital gains are taxed like the above table.
This is why long-term capital gains are better than short-term capital gains.
By holding your investment for more than 1 year, you could potentially save thousands or tens of thousands in taxes.
Let’s look at a few common investments:
An active fund trades more often than a passive fund.
The fund manager is buying and selling securities in an attempt to beat the market.
Because they are constantly buying and selling, they are potentially generating short-term capital gains.
A passive fund, on the other hand, trades less often, because it is mirroring an index. Not trying to beat it.
As a result, a passive fund is more likely to have long-term capital gains.
Active funds = tax-inefficient
Passive funds = tax-efficient
Some stocks don’t pay any dividends and as a result, hopefully, are appreciating.
If you don’t sell, there is no tax impact.
But if they do pay dividends, they likely pay qualified dividends.
Qualified dividends are taxed at the preferential capital gains rate.
Bonds, on the other hand, pay interest.
Interest is taxed as ordinary income.
Stocks (& qualified dividends) = tax-efficient
Bonds = tax-inefficient
Real Estate Investment Trusts (or REITs) pay non-qualified dividends.
Non-qualified dividends are taxed as ordinary income.
REITs = Tax-inefficient
The interest from municipal bonds is exempt from federal income tax.
It can also be exempt from state tax (if purchased in your home state).
Munis = tax-efficient