Lessons from the Pros


Tax Considerations for Investors

It’s near the end of the year, when every young (or old) man’s (or woman’s) thoughts turn to taxes.

For investors, there are several things to think about regarding taxes. We’ll talk here about one of the more significant ones.

Note: These comments are for educational purposes only. Before making any decision regarding taxes, you should get advice from a qualified tax professional who is familiar with the tax issues regarding trading and investing. If you need help along these lines, the OTA Tax Pros can assist.

With that in mind, here are some areas to think about.

Types of Returns Generated by Investments

Your investments should be in a diversified group of assets. Some of those assets generate returns in the form of cash flow – interest, dividends, rents and royalties. Examples include bank accounts, bonds, annuities and preferred stocks.

Other assets generate returns mainly from capital appreciation – increases in value, which you eventually realize by selling the assets at prices higher than your cost. Examples of these growth-oriented assets include common stocks and precious metals.

Some assets have the potential both for cash flow and for capital appreciation – dividend-paying common stocks, real estate and REITS are examples.

Each asset will have an expected total rate of return. In general, cash-flow-generating assets provide lower average rates of return than growth-type assets, while being much less variable in their returns from year to year.

You should have money allocated to several different assets in multiple categories, for the reasons discussed in earlier articles.

A calculator, pair of glasses and pen laying on a financial document.

Tax Treatment of Various Investments

You probably have your various assets held in different accounts. Some of those accounts may have special tax treatment:

In the U.S., in a traditional Individual Retirement Account, income and gains are not taxed currently. The money is taxed eventually when you withdraw it out, and only to the extent that you withdraw it in a given year. Money in your employer’s 401(k), 403(b), 457 or TSP is also tax-deferred.

Annuities are tax-deferred, sort of, in that you are taxed on only part of the periodic annuity payments. This is because most of the dollars you receive represent repayments to you of your own principal. This is not a real tax deferral but appears like one.

In a Roth IRA, gains and income are completely tax-free. You paid tax on the contributions when you put them into the Roth and are not taxed again when you withdraw the funds.

Free Trading WorkshopSo, our order of precedence should be to place the assets that you expect to have the highest return in a tax-free environment like a Roth IRA, if available; the next-highest in a tax-deferred mode like a traditional IRA or in stock funds within your 401(k), to the extent possible; and the balance in accounts that are fully taxed. In a few words: to the maximum extent that you are able, put capital that will earn the most where it will be taxed the least.

Example of Growth in a Tax Deferred vs. Non-Tax Deferred Investment

The following example helps illustrate the benefits of putting assets into a deferred-tax environment like a traditional IRA. It starts with a balance of $1,000 and an assumed annual pre-tax return of 5% annually, where the money is left to accumulate over a period of ten years, at which point the accumulated income is withdrawn.

It shows the difference in after-tax returns between two alternatives for the placement of this asset: a currently taxed account, where tax is paid on the income each year even though it is not withdrawn (no deferral); and a tax deferred account, where the gains are not taxed until they are withdrawn at the end of the ten years. Results are shown for various income tax rates. All examples make a very simple assumption, which is that the investor’s tax rate remains the same for the entire period. Your mileage will vary.

Example of the Benefit of Tax Deferral
Annual Yield 5%
End of Year Balance if compounded Deferred Income No-Deferral Annual Tax at Tax Rate Shown
10% 22% 32% 37%
0 1000
1 1050 $5.00 $11.00 $16.00 $18.50
2 1103 $5.00 $11.00 $16.00 $18.50
3 1158 $5.00 $11.00 $16.00 $18.50
4 1216 $5.00 $11.00 $16.00 $18.50
5 1276 $5.00 $11.00 $16.00 $18.50
6 1340 $5.00 $11.00 $16.00 $18.50
7 1407 $5.00 $11.00 $16.00 $18.50
8 1477 $5.00 $11.00 $16.00 $18.50
9 1551 $5.00 $11.00 $16.00 $18.50
10 1629 629 $5.00 $11.00 $16.00 $18.50
Ten-year Total Income without Deferral 500 500 500 500
Ten-year Total Tax – no deferral $50 $110 $160 $185
Total after-tax income – no deferral $450 $390 $340 $315
Ten-year Total Tax – with deferral $63 $138 $201 $233
Total after-tax income – with deferral $566 $491 $428 $396
Percentage improvement from deferral 25.78% 25.78% 25.78% 25.78%

The result of the tax deferral is that not paying the tax each year leaves more in the account to generate returns, so that the total amount of pre-tax income is higher – in the above case a total of $629 in pre-tax income instead of $500. Even though you do eventually pay tax on a higher amount, your after-tax income is still higher with the deferral. (This does not account for the time value of the tax savings, which would make the difference even higher). The higher your income tax rate, the more you save in total dollars. The percentage improvement in your after-tax return from the deferred account compared to the non-deferred account is the same no matter what the tax rate – you net over 25% more after-tax income.

For assets with higher rates of return, the benefit of the deferral is even greater. Below is the same example but with an 8% annual pre-tax return.

Example of the Benefit of Tax Deferral
Annual Yield 8%
End of Year Balance if compounded Deferred Income No-Deferral Annual Tax at Tax Rate Shown
10% 22% 32% 37%
0 1000
1 1080 $8.00 $17.60 $25.60 $29.60
2 1166 $8.00 $17.60 $25.60 $29.60
3 1260 $8.00 $17.60 $25.60 $29.60
4 1360 $8.00 $17.60 $25.60 $29.60
5 1469 $8.00 $17.60 $25.60 $29.60
6 1587 $8.00 $17.60 $25.60 $29.60
7 1714 $8.00 $17.60 $25.60 $29.60
8 1851 $8.00 $17.60 $25.60 $29.60
9 1999 $8.00 $17.60 $25.60 $29.60
10 2159 1159 $8.00 $17.60 $25.60 $29.60
Ten-year Total Income without Deferral 800 800 800 800
Ten-year Total Tax – no deferral $80 $176 $256 $296
Total after-tax income – no deferral $720 $624 $544 $504
Ten-year Total Tax – with deferral $116 $255 $371 $429
Total after-tax income – with deferral $1,043 $904 $788 $730
Percentage improvement from deferral 44.87% 44.87% 44.87% 44.87%

In this case, the benefit of the deferral is almost 45% more after-tax income.

I hope this has given you something to think about as to the deployment of your investment assets. There are many more tax-related matters to consider, but this one could be one of the most significant.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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