Taxes Are the Most Significant Investment Expense You Will Pay

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Just as paying seemingly modest fees for money management every year can stunningly reduce your wealth over time, paying seemingly modest taxes every year can sharply impact your quality of life in retirement. Money that is not in a tax-sheltered retirement account (more on these below) is subject to four types of taxes:

  • Income taxes. Interest earned from bonds is taxed at the ordinary income rate, which can be as high as 35% at the federal level.
  • Capital gains taxes. If an investment is sold for a higher price than it was purchased for, the difference is termed a capital gain and is subject to tax. If the investment producing the gain was held for a year or longer, a special capital gains tax rate of (usually) 15% applies. If the investment was held for less than a year, it is taxed at the full ordinary income rate (up to 35%).
  • Dividend taxes. Dividends received from stocks are taxed either at the ordinary income rate or at a qualified dividend rate, which may be lower (currently 15% for most taxpayers).
  • State and local taxes. States usually do not differentiate between sources of income, so whatever you make from your investments will be taxed at the income rate (unless you are lucky enough to live in a tax-free state like Nevada, Texas, or Washington).

Be aware that tax rates have changed markedly in the past and are likely to increase in the future.

Together, these taxes act as a sharp brake on the amazing effects of compound interest, which we covered in Chapter 1. To see the huge potential impact that taxes can make, let’s assume that you are in the 33% tax bracket and have $100,000 invested in a long-term bond that pays out 6% interest a year. If you re-invest your proceeds every year, this money will actually compound at 6% inside a tax-sheltered account, growing to $575,000 over the course of 30 years. Outside a 401(k) or other tax-sheltered account, this money will compound at a true after-tax rate of only 4% (since 1/3 of the income will go to the government every year), growing to only $324,000 (see Figure 5). Once again, seemingly minor annual savings add up to a gigantic, $250,000 difference in final wealth over time.

Figure 5 – Tax-advantaged accounts can compound wealth at a much faster rate than regular accounts

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The two major tax-advantaged account types that you must become familiar with to be an informed investor are the 401(k) and the Individual Retirement Account (IRA).