Tax-Friendly Investments in the USA
We all know how it feels to work for our wealth, only to pay a significant portion of it to the government. Of course, we must pay our dues but it would be nice to keep as much of it for ourselves as possible, right? We thought so too. Well, it should be no different when it comes to your investment income since we all know that gets taxed too.
Some basic terminology for tax-conscious investing.
Considering tax implications when investing can significantly affect how much you pay in taxes each year. Just to lay out some basic terminology, consider the following. You have your gross income (amount you make in total), taxable income (amount of gross income subject to taxes), and net income (amount left after taxes). You also have taxable income deductions, which is the difference between your gross and taxable income, as well as tax credits which can be used to pay the taxes due on your gross earnings.
Tax deferring versus regular investment accounts.
You can hold your investments in different accounts. There are some which are considered to be tax deferring accounts (such as your 401k, IRA), as well as regular investment accounts (like individual, joint, or money market mutual funds).
The difference lies in the fact that tax deferring accounts hold your investment income and are not subject to tax until the year in which they are withdrawn. On the other hand, regular investment accounts are subject to tax on an annual basis.
Tax-sensitive investments versus non-sensitive ones.
As you may or may not know, particular types of investments are taxed differently than others. Some can be described as being tax-sensitive, while others not so much. Let’s start with those that are not immune to the nation’s tax laws.
Common stock dividends: any proceeds from your stocks in the form of dividends are taxed the same as ordinary income.
Preferred stock dividends: just like common stock dividends, preferred dividends are also taxed like normal income
Junk bonds: due to the nature of these bonds, they are taxed like ordinary income
Now here are the ones that receive preferential treatment when it comes time to do your taxes.
REIT: these are subject to tax benefits at the corporate and individual level (read all about these here(link to REIT article)
Corporate and convertible bonds: assuming you hold this for more than a year, any gain is considered capital gains which is subject to a capped tax level. In the case that you lose money on your bonds, it may be declared as capital losses.
Common stock (in terms of capital gains): capital gains are taxed at a discounted rate
The final verdict.
Now that you’ve got some exposure to the different tax treatments of various investment accounts, as well as different asset types, you can better understand how to organize your personal investments. Knowing this, it makes sense to put your tax-friendly investments into regular investment accounts and your not-so-tax-friendly investments in a tax deferred account. The reason for this is that since the regular accounts will be taxed as normal, it makes sense to populate them with assets that will themselves receive preferential tax treatment. On the other hand, it makes sense to shelter those non-sensitive tax investments in a tax deferred account so it isn’t subject to tax until later in life.
So now that you know what is available to you on the market, we will discuss the concept of a marginal tax bracket in our next article.
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