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Don't Let Taxes Eat Away at Your Nest Egg: A Simple Guide to Tax-Smart Investing

Don't Let Taxes Eat Away at Your Nest Egg: A Simple Guide to Tax-Smart Investing

March 26, 2024

Tax season is in full swing, and your mailbox is probably stuffed with those dreaded envelopes marked "Important Tax Documents." But don't just toss them aside - understanding how your investments are taxed is critical to keeping more of your hard-earned money.

Here's the deal: There are three main ways the tax man can take a bite out of your portfolio - through interest income, dividends, and capital gains. And if you're not careful, those bites can really add up over time.

So, let's break it down, one tax at a time:

Interest Income: The Silent Growth-Killer

Think those boring old savings accounts and bond funds are completely safe? Think again. The interest you earn is taxed as ordinary income, just like the money you make from your job. Harsh, right?

At least Treasuries get a small break by being exempt from state taxes. But for those who believe municipal bonds are tax free - it's a mixed bag. They avoid federal taxes but may still get taxed at the state and local levels, they could push you into the dreaded alternative minimum tax or even cause taxes on your social security benefit.

Dividends: A Tricky Tango

On the surface, dividends seem straightforward. Companies pay you a slice of the profits for being a loyal shareholder. But as the great RUN DMC said – It’s TRICKY...

You see, dividends can be taxed in two very different ways - as ordinary income, or with lower capital gains rates. What is the difference? Some are considered qualified while others are considered capital gains. The determining factor? It boils down to how long you’ve held the stock.

So, if you tend to buy and sell shares quickly - you just punched your ticket for higher taxes on those dividend payments.

Capital Gains: The Biggest Boogeyman of All

Finally, we have capital gains. This is the profit you make when selling an investment for more than you paid. Naturally, profits are better than losses, but those profits can come with some serious strings attached tax-wise.

Whether those gains are considered long-term or short-term makes a MASSIVE difference in your tax rate. If you held those investments for longer than a year, you're in the relatively low capital gains bracket (0-20%). Held them for less than a year? Short-term ordinary income rates apply (0-37%) - which can be a real kick in the pants.

And You’re not off the hook if your portfolio is down overall - Mutual funds can and often times do, still be handing out capital gains distributions behind the scenes.

3.8% Wealth Tax?

But wait, there's more! If your income crosses a certain threshold ($200k for singles, $250k for married couples), you could be hit with the Net Investment Income Tax (NIIT) – which is an extra 3.8% tax on interest, dividends, rental income and capital gains.

Doesn't seem fair for the moderately wealthy, does it? I don’t consider earning $200,000 per year to be Ultra-High Net Worth or “Rich.” It’s just another reason to be tax-aware with your investments.


So How Can You Fight Back? Look, I get it - doing complex tax planning probably isn't your idea of a fun weekend. But with a few strategic moves, you can take a big bite out of your annual tax bill and lifetime tax burden:

  • Favor long-term holdings to get those qualified dividend and long-term cap gain rates.
  • Tax-loss harvest by selling losers each year to offset winners.
  • Never hold tax-inefficient stuff like bonds or REITs in taxable accounts.

 

At the end of the day, a penny saved from the IRS is a penny earned that can go a long way to growing your wealth and securing your retirement. And in this high-stakes game of growing your nest egg, you need every edge you can get.

So, be proactive, get smart about asset location and holding periods, and stop paying taxes that could otherwise be avoidable. It’s like flushing money down the tax drain. With some simple planning, you can keep more of what's yours - and ultimately reach your goals faster.


If you would like to discuss your current situation schedule a free 20-minute call with the link below.

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About the Author

James M. Comblo, CFF
is the President & CEO of FSC Wealth Advisors. His greatest passion in the financial services industry is helping clients live the life they want, not the life they are forced to. To learn more about him click here.