The true tax advantage
Don't just lower your taxes, increase your after-tax earnings.
NEW YORK (Money) -- Question: I'm tired of paying so much in taxes. What investments will lower my taxes?
The Mole's Answer: I am frequently asked this very question. And though it seems absolutely logical, it's really not the right question to ask. The better question would be how you can increase your earnings after paying taxes.
I often have clients come in with investments that their previous adviser put them in which successfully lowered their taxes, as if that were the goal. As is typically the case, it also lowered their after-tax return. Let's first look at a couple of examples and then talk about how you can increase your after-tax earnings.
A "muni" bond is issued by a state, county or municipality and the holder of these bonds doesn't have to pay federal taxes. In some cases, they are also state tax-exempt. That certainly would lower your taxes, but still may not be the right thing for you.
As of the time of this writing, a five-year AAA rated muni bond paid an average of 2.92%. That means a $10,000 investment would yield $292 annually, with nothing going to Uncle Sam!
But an equivalent, five-year AAA taxable bond averaged a 4.46% annual return, or $446 before any taxes. A taxpayer in the 25% marginal tax bracket would have to pay $112 in taxes. Still, even after the tax bill, this bond would leave $334.
So the bottom line is that the muni bond did save $112 in taxes yet, after all was said and done, also yielded the investor $42 less than the taxable bond. A tax payer would have to be over the 35% combined tax bracket for the muni to make sense.
When I go through the math with a client, they typically tell me the planner who sold it to them said it would be easy to get out of. That's when I get to deliver the news that, actually, these muni bonds rarely trade, and you often have to pay what's called a spread of 2% to 3% to get out. That happens to be one of those hidden costs you'll never see.
Many planners often sell whole life insurance, universal life insurance, variable annuities, equity-indexed annuities and other flavors of insurance products with the promise of paying lower taxes.
When clients come to me having been sold these products, I have the task of telling them they accomplished the goal of paying less in taxes. Unfortunately, these products are so expensive that the returns are usually very low.
And it gets worse. Even the small returns are usually taxed at the highest ordinary income tax rates So the "tax advantage" here is really just a deferment. Of course, you can often borrow back your money, but the economics of paying to use your own money doesn't sit right with me.
As for getting out of these investments, it makes the costs of selling munis look low. They almost always have surrender charges built in. For example, some insurance policies have a 7% penalty the first year and drop by 1% per year and I've seen them go as high as 30%. I guess they don't call it permanent insurance for nothing.
My Advice: Always remember that your goal is to increase your portfolio value, after taxes.
Broad stock index funds happen to have that wonderful combination of having one of the best returns with the best tax-efficiency. The dividends are taxed at the 15% dividend rate while the gains are mostly tax-deferred, as you usually don't have to pay capital gains until you sell. And when you do sell, you can take advantage of the 15% long-term capital gains rate as long as you've owned the fund for longer than a year.
For the part of your portfolio you want in bonds, most of us are far better off owning taxable bonds or certificates of deposits in our tax-deferred accounts. That's right, where we locate our assets is what provides the most tax-efficiency.
Remember that the goal of tax-efficiency is to increase the amount you have left, after paying all taxes. Many Wall Street experts conveniently muddle the true goal by harping on paying less taxes. But this misdirected focus ends up costing you instead - less taxes don't always mean having more money after paying those taxes.
The Mole is a certified financial planner and certified public accountant who - in the interest of fairness - thinks you should know what goes on behind the scenes in financial planning. Want to make contact? E-mail firstname.lastname@example.org.Send feedback to Money Magazine