How Taxation Rules Your Investment Options
By Shane Flait © 2009

You grow your savings so to use them later. Outside of contributing they grow according to how you invest them. Government’s taxation plays an important part in how you choose what to invest in and how to hold that investment.

 

This article overviews how your savings or investments are taxed and how that influences what you choose to invest in.

 

Taxation affects growing your savings three ways. It

1.      Affects how much you’re able to contribute to your savings from your working income

2.      Determines how much of your investment earnings will be taxed annually

3.      Takes a share of the your investment gains when you sell them

 

Because of this omnipresence of taxes at every savings or investment interaction, you must understand how taxes work so you can minimize their drain on your savings. So, here’s how to ‘view’ your savings and investment in relation to how they’re affected by taxation.

 

First, let’s categorize investment types according to how they ‘hopefully’ increase.

 

There are two fundamental types of investments. They are:

·         Debt-based investments, and

·         Equity-based investments

 

Debt-based investments ‘borrow’ money from you and pay you ‘interest’ at least annually for the use of your money. At the end of the borrowing term – if there is a term at all- all your money is returned to you. 

 

Examples are your bank savings accounts, CDs, bonds, and the like. These investments kick out an ‘annual’ income for you to use or reinvest as you wish. They’re also ‘income-based’ investment for those seeking some relatively assured annual income from their investments.

 

Interest earnings are taxed annually; they’re added to your income to be taxed as your highest income tax rate. Only earnings are taxed - not what you loaned to get the earnings.

 

Equity-based investments require you to ‘buy so as to own’ an investment – perhaps a share in a company (like stock). Your share or ownership value – called capital - hopefully will increase in time so when you sell your share you’ll receive back more than you paid; but there’s no guarantee.

 

The gain of what you receive over what you paid (called your basis in capital) is called your capital gain. Most equity-based investors seek capital growth.

 

Capital gains are taxed only when you sell your equity-based investments. These are taxed at very low capital gains tax rates if you hold your investment for more than 1 year. Your capital basis is never taxed.

 

Some equity-based investments promise a yearly dividend (earnings) too. These relatively assured earnings make ‘dividend- paying’ equities an ‘income-based’ investment like debt-based investments.

 

Dividends are taxed annually. Generally they’re taxes like interest. But some are taxed at low tax rates depending on what income tax bracket you’re in.

 

I’ll call investments you make in equity-based and income-based subject to the taxation I’ve outlined above ‘normal taxable investments’.

 

The government has set up and regulates retirement-savings plans as an incentive for workers to save for retirement. Examples are 401(k) and IRA savings plans. The incentive is tax-based and prescribes a completely different taxation method for whatever investment type you use within these plans.

 

The taxation procedures for these government-regulated plans are:

·         All contributions to these plans are deductible from working income. This eliminates the income tax that would be due on what you contributed to the plan that year.

·         All earnings or gains from what you invested in within the plan are tax-deferred until you withdraw your plan savings at retirement.

·         All withdrawals will be subject to your income tax rates. Withdrawal before you turn 59½ will include penalties in addition to the income tax.

 

So, you should view all your savings as partitioned under the two taxing systems for savings:

·         Normal taxable investments

·         Regulated-savings plans

 

These tax attributes determine your investment options as follows:

Normal taxable investments

Income-based investments are generally highly taxed - interest earnings at your highest income tax bracket as for nonqualified dividends. Qualified dividend earnings may have lower 0% to 15% tax rates though. So, choose generally assured earnings only if you need the yearly earnings to live on and for an emergency fund.

 

Equity-based investments have their capital gains taxed at low rates (5% or 15%) if held for more than 1 year - otherwise at income tax rates. These are clearly tax-advantaged investments to use to grow your savings over the long term.

 

Regulated-savings plans

These help you put more into your savings every year – but contributions are limited. Always contribute when your company matches your contributions. Their tax-deferred character helps yearly compounding too. Choose high earning income-based investments for their assurance.

 

The best long term growth approach is in equity-based capital growth items – stocks and residential property - held as normal taxable investments.

Shane Flait is a writer and educator. See more at www.EasyRetirementKnowHow.com