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Evaluating Investments on an After-Tax Basis

Evaluating Investments on an After-Tax Basis

Most people think of the returns on their investments simply based on what they paid on purchase and what they receive on sale. Ignoring the income tax consequences can result in only a partially complete view of the investment results.

Some basics

  1. Interest is taxed at ordinary income tax rates. The federal marginal rates range from 10% to 39.6%.
  2. Interest from most bonds issued by states, cities and other municipalities is exempt from federal income tax.
  3. Capital gains can receive beneficial tax treatment if the underlying security is held for a year or longer. The long-term capital gains rates are 0% to 20% depending on your level of taxable income.
  4. Qualified dividends also receive beneficial tax treatment like long term capital gains.
  5. Beginning in 2014, there is a Medicare surtax of 3.9% applied to long term capital gains and dividends for high income earners.
  6. Net capital losses up to $3,000 in a year can be deducted against ordinary income. Net capital losses in excess of $3,000 can be carried forward to offset future capital gains.
  7. Earnings on investments within a qualified plan or a regular IRA are tax deferred. That is, there is no current tax, however distributions are taxed when taken at ordinary income tax rates.
  8. Roth IRAs offer the additional benefit of the distributions being exempt from income tax.
  9. Distributions from mutual funds usually are treated as a combination of dividends and capital gains with corresponding taxation.
  10. State income taxes should be considered. Many states follow the federal tax rules, but some do not.

Issues to consider

  • If you are in a high marginal tax bracket, you may want to compare the return of a tax-free municipal bond with the after-tax return of a similar quality and similar maturity taxable bond.
    The formula to calculate the after tax return of the taxable bond is: After tax return = Taxable return minus (taxable return times marginal tax bracket) For example, if you are in the 35% tax bracket and are considering a taxable 6% bond, the after tax return would be equal to 3.9% = [6% - (6% times .35)].
  • If you are considering selling a stock in which you have a gain and the one year holding period is nearing, you may want to wait until after the one year has elapsed so the gain will be taxed at the favorable capital gains rate. However, before making this decision, fully evaluate the risk of holding it longer. Often, the hope of lower taxes causes people to make unwise investment decisions.
  • The tax deferral benefits of retirement plans and IRAs should not be overlooked. They represent one of the best ways to reduce current taxes and take advantage of the power of compounding. If you can afford it, try to take full advantage of opportunities to contribute to these plans.
  • If one of your financial goals is to fund the college education of a child, be sure to fully evaluate the pros and cons of custodial accounts, education IRAs and Section 529 Plans. The 2001 Tax Law made some significant enhancements to the education IRAs and Section 529 Plan rules.

Summary

Income taxes are part of everyone’s financial life and no one likes to pay more than absolutely required. Understanding how the tax laws apply to your investments can help you make wise decisions from both an investment and tax point of view.

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