Written by: Greg Palacorolla, CFP®
Asset allocation, fund manager selection, understanding the current economic landscape and regular rebalancing are all crucial elements to successfully growing your portfolio over the long-term. However, a frequently overlooked factor to the consistent growth of your assets are the taxes associated with investing. Compounding (the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings) is the most powerful piece to the long-term growth of your portfolio.
Therefore, the best way to maximize your ability to compound your investments year over year is to manage and minimize the taxes on capital gains, interest & dividends.
Understanding Capital Gains Tax
Capital gains are profits that an investor realizes when an investment is sold at a price higher than the initial purchase price. These capital gains are subject to tax and can substantially reduce your overall gain. It is important to understand that this tax is only triggered when a gain is realized, or sold, and not just as the asset appreciates in value. For example, if you purchased Microsoft at $35 per share and it rises to $48 per share two months later, you are not subject to capital gains tax. Once you have liquidated that position and realize a $13 per share gain, you have generated a taxable event. However, the length of time that you owned Microsoft will dictate the specific rate in which you are taxed.
Short-Term Capital Gain
If you buy and sell an asset within one year, all profits are considered short-term capital gains. Short-term capital gains are taxed at ordinary income tax rates, which for high-income earners, could be close to 40% on the federal side. Tack on another 5-10% to your home state income tax and your $13 gain per share in Microsoft is virtually cut in half.
Long-Term Capital Gain
If you hold an asset for longer than one year, all realized profits would be subject to long-term capital gains tax, which is tax at a more favorable rate. This is an effort by the government to encourage long-term investing rather than day trading. Your current marginal tax bracket determines your long-term capital gain rate. If your ordinary tax rate is 10% – 15%, your long-term capital gain rate is 0%. For those who are currently in a marginal tax bracket between 25-35%, the long-term capital gain rate is 15%. For ultra-high earning individuals in the 39.6% federal bracket, the long-term capital gain rate is 20%. Therefore, if you held your Microsoft position for 13 months, you would keep 80%-100% of your gain.
Understanding Interest & Dividend Tax
In addition to the potential capital gain taxes imposed, investors need to be cognizant of the taxes on interest and dividends that their stocks and bonds generate. An investor buys a bond to receive a semi-annual, low-risk, predictable interest payment. It is comforting to know that twice a year you will receive an interest payment on your investment and at maturity you should receive your entire principal. Sometimes, when you own a stock, in addition to the expectation of appreciation, you are awarded a monthly, quarterly, or annual dividend payment. This payment is not guaranteed or fixed; often times it fluctuates in amount, but shareholders are given this “bonus” by the company in which they are invested in. While interest and dividend are often supplementary components of the ultimate growth of the portfolio, when compounded, they can add significant value. However, there are tax considerations that must be understood before investing in interest or dividend-paying vehicles.
Tax on Interest Income
Interest payments are taxed as ordinary income. As stated previously, this rate can be close to 40% federally along with applicable state income taxes. Therefore, if you purchased a $10,000 bond paying 5% interest per year, you would be paid $500/year. However, if you were in a 25% marginal federal income tax bracket and a 7% state bracket, your $500 payment would net you $340 (32% to taxes). Therefore, the effective rate of a taxable bond paying 5% is actually closer to 3.4%.
Tax on Dividend Income
Similar to long-term capital gains, dividends receive favorable tax treatment as long as certain qualifications are met. In order to receive a dividend, an investor must be an owner of the stock on a certain date, known as the ex-dividend date. If you held the position more than 60 days during 121 day period that begins 60 days before the ex-dividend date, then the payment is considered qualified and will be subject to the reduced, long-term capital gains rate mentioned above. As a result, investors will often purchase the position a few days prior to this date so they are the owner of record. Again, in an effort to encourage long-term investing, the government considers “nonqualified” dividends as ordinary income and subject to ordinary income tax rates (up to 39.6%).
The “Sneaky” Net Investment Income
If the capital gains and interest/dividend income tax rates were not confusing enough, the government enacted a law beginning in 2013 that adds another layer of tax to investors. The net investment income tax is an additional 3.8% surtax on capital gains, interest, and dividends that applies to individuals and families with the following levels of income (MAGI):
- Married Filing Jointly – $250,000
- Married Filing Separately – $125,000
- Single – $200,000
What to Do? Invest Strategically & Tax-Efficiently
While your ability to let your investments compound is hindered by the IRS enforcement of a plethora of taxes, there are several strategies, types of accounts, and specific investments that can help limit or reduce your liability. These strategies will allow you to keep more of what you earn and increase the impact of compounding, thus allowing your portfolio to grow at a faster pace.
Be Aware of Trading Dates
As I’ve discussed throughout this blog, there are significant benefits to investing with a long-term outlook. Realizing a gain after one year or holding a stock for the required 61 days in the 121 day period will maximize your after-tax return as you will benefit from the lower capital gain rates.
Maximize Investment in Retirement Accounts
The various taxes discussed above only affect non-retirement accounts. Because of contribution limitations to investing in retirement accounts, non-retirement accounts are funded to expedite reaching retirement goals. However, as I’ve described above, these types of accounts require significantly more attention and tax planning than a retirement account. Therefore, I would encourage investors to fund their company 401k, 403(b), & 457’s along with their personal IRA’s as much as possible. All of these investments are either tax-deferred or tax-free (see our blog: Roth vs Traditional IRA), which allows the entire portfolio to compound indefinitely. These accounts are so tax-advantageous to an investor that the IRS limits how much can be deposited into them. But, if you have limited cash available for investment, seek funding your 401k or IRA’s first, so your investments are not immediately subject to tax.
Buy Municipal Bonds
If you are investing outside of a retirement vehicle, one specific asset provides tax-free income – municipal bonds. Municipal bonds are issued by a state or county to finance its capital expenditures. To increase the support for municipalities, the interest earned on muni bonds are federally income tax free. If you purchase a municipal bond issued by your resident state, the bond interest is exempt from both federal and state income tax. The yields on these bonds tend to be less than a government or corporate bond, but the impact of tax-free interest must be accounted for. Therefore, you should calculate your tax-equivalent yield, which essentially compares your return of a higher yielding, taxable bond vs. a tax-exempt, muni bond. For investors in high income brackets, municipal bonds usually offer great value.
Geier Asset Management’s Approach
As you can see, the tax implications associated with investing in non-retirement accounts cannot be overlooked. It could cripple your portfolio in both the short and long-term, thus prohibiting you from achieving your goals. With the proper attention and understanding of the constantly changing tax law and strategic asset allocation, you can limit the tax burden.
Geier Asset Management evolved from an accounting firm. As a result, we strongly emphasize the tax considerations of all client decisions, specifically those related to their portfolios. Thorough, year-round tax planning is conducted by our team of CPA’s and accounting professionals to ensure that your portfolio is managed as tax efficiently as possible. Do not ignore the tax implications of investing – WE CERTAINLY DO NOT!
© Geier Asset Management, Inc. February 2015. Greg Palacorolla is the Director of Wealth Management for Geier Asset Management, Inc., a Registered Investment Advisor. The above blog reflects the opinions of Mr. Palacorolla and not necessarily the firm. Any advice given is general in nature and investors must consider their own individual circumstances. Past performance is no indicator of future performance. The firm makes no warranties or representations of any kind relating to the accuracy or timeliness of the information provided.