Taxes on Investment Income

Paying attention to the way various investments are taxed can add one to three percent per year to your investment returns with little or no effort. Sadly, scant attention is paid to how investments are taxed. Even many investment advisors are guilty of this omission. The process of minimizing current income taxes incurred on investments is called "tax efficient investing," and you don't have to be a CPA to master many of the straightforward strategies for doing so. Studies have shown that taking simple steps to minimize taxes on investments can add anywhere from one to three percent to after-tax return which, over the years and decades, can add substantially to your wealth.

Tax efficiency varies among investments. Figuring out the tax ramifications of a stock or a bond held in a taxable brokerage account is easy. Here's a rundown:

  • Capital gains taxes are not due until the stock or bond is sold, so you're in control of the timing of capital gains taxes. If and investment is sold at a loss, the loss can generally be used to offset capital gains as well as a small amount of other income.
  • Cash dividends paid to stockholders are generally taxable federally at a rate of 15%.
  • Corporate bond and government mortgage bond interest is subject to federal and state income taxes
  • U.S. Treasury interest is subject to federal but not state income taxes.
  • Municipal bond interest is generally not subject to federal income taxes (but may be subject to the diabolical "alternative minimum tax"). If the municipal bond is issued in your state of residence, its interest is usually not subject to state income taxes; if issued in another state, state income taxes have to be paid.
  • Mutual funds. Tax planning gets more complicated with mutual funds. The relative tax efficiency of a mutual fund depends largely upon the fund's investment objective and the way in which it is managed. At one extreme, all or virtually all of the income distributed by single-state municipal money-market funds is tax-exempt to state residents. At the other end, stock funds striving for growth often distribute large capital gains to shareholders. And for funds that trade frequently, many of these capital gains could be short term, which bumps up the capital gains tax rate. Between the two extremes are endless varieties in terms of tax efficiencies. Funds that invest in municipal securities are the most tax efficient because of the federal and perhaps state exemption of muni interest income. Nevertheless, any realized capital gains earned by a muni fund - or any fund for that matter-are subject to tax. With respect to stock funds, index funds are more tax-efficient than actively-managed funds. There are some funds within most stock fund categories, referred to as "tax managed funds" that are intentionally managed to minimize taxes.

You shouldn't let taxes override other considerations that are often more important, including past investment performance and how a particular fund complements your other investment holdings. Taxes should, however, receive at least some consideration when you select a mutual fund for a taxable account. After all, income taxes can easily consume one-quarter or more of your investment income. Anything that can be done to minimize that bite while still meeting your overall investment objectives merits your serious attention.