Tax Considerations Should Play a Role in Your Investments

As famed investor Warren Buffett said, the only thing that matters is how many hamburgers you can buy at the end of the day. It’s amazing how few professional portfolio managers focus on pre-tax returns rather than after-tax returns. Many trade frequently and although they may earn 12% for their investors, if those investors are in a high tax bracket, they’ll end up with less than a more conservative manager that made 10% but structured the investments with an eye on April 15th. Why? In addition to the enormous cost savings that result from long-term investing (as opposed to short-term trading) there are several tax advantages. Here are a few reasons:

• Short-term gains are taxed at personal income tax rates. In New York City, for example, Federal, State, and Local taxes on these types of short-term gains can meet or exceed 50%! Long-term gains – that is, those generated from investments held over one years – are typically taxed at only 20% and in some cases, even lower.

• Unrealized gains are a sort of “float” on which you can continue to experience the benefit of compounding your money. If you sell your investment to the move the money into a new stock, bond, or mutual fund, you are not only going to have to pay commissions, but you are going to have to give the tax man his cut of your profits. That means the amount you have available to reinvest is going to be substantially lower than the amount shown on your balance sheet just before you liquidated the position. That’s why the best investment minds, such as Benjamin Graham, said you should only consider switching out of one investment and into another if you think the new position is far more attractive than your current one. In other words, it’s not enough for it to be a “little” more attractive - it needs to be absoultely evident to you.

• Where you hold your investments is vital. If you own shares of many different companies, some issues are likely to pay large cash dividends (think banks) and others to retain all of their profit to fund future expansion (think Starbucks). Dividends are taxed at 15% (before the Bush administration, it was as high as personal income tax rates, or over 35%), meaning that you would end up with only a fraction of the ultimate wealth you could have if there were no dividend tax. By keeping all of your dividend paying stocks in your tax-advantaged accounts such as a Roth IRA or Traditional IRA, however, you can avoid paying these taxes.

• Always, always, always contribute to your 401k at least up to the amount of your employer match. If your employer matches $1 for $1 on the first 3%, for example, you are instantly earning a 100% return on your money without taking any risk!