by Robert Rapier, Investing Daily
Investing Daily Article of the Week
During most of my career, I contributed the maximum amount to my 401(k) account. I always reasoned that it was better to defer those taxes and let that money grow tax-deferred until I retire.
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This was especially important when I was working in locations that had a state income tax. I reasoned that if I retired in a state without a state income tax, I would get to keep the wealth derived from those deferred state income taxes.
That’s certainly a prescription for accumulating wealth for your retirement. However, over time I began to see a large discrepancy between my tax-deferred accounts and my completely liquid accounts (i.e., those I could access with no penalties).
Shifting Strategies
I started to realize that maybe maximizing my tax-deferred savings wasn’t the best strategy. There was really no point in continuing to pile up my post-retirement savings at the expense of my liquid savings.
So I switched strategies and began to only contribute the amount that my employer matched. I started saving the excess in taxable accounts, so I could build more wealth that I could access penalty-free as needed.
My point was that as I grew older, I began to think about the tax implications of my investments in a different way. I began to more carefully consider the implications of conventional accounts versus retirement accounts.
Getting the Best Net Return
I also began to pay a lot more attention to short-term versus long-term capital gains. Long-term gains are those derived from investments held longer than one year. They are taxed at 15% or less for most people, and at 20% for those in the highest tax bracket.
Contrast that with gains on investments held less than one year. These gains are taxed at the ordinary income tax rate of the investor, which can be nearly 20% greater than the tax from long-term gains.
What that means is that you have to make sure you are being sufficiently compensated for short-term gains. Your acceptable annual return for short-term trades needs to be higher to offset the higher tax rate.
The difference in the two capital gains rates is large enough that I prefer to hold my investments for longer than a year. If I earned 20% on a 10,000 investment that I held for 360 days, I might have paid 35% of that $2,000 profit ($700). My after-tax return is reduced to 13%.
Contrast that with the same investment held for just a week longer. In that case, I could have paid only 15% in long-term gains ($300), for an after-tax return of 17%. That difference can really add up over time.
Note that with tax reform, the marginal tax rate for most people will decline this year. Thus, the difference between short- and long-term capital gains will decline somewhat. For example, if you are married and have $200,000 a year of taxable income, your marginal tax rate will decline from 28% to 24%. But the long-term capital gains rate, in this case, remains 15%.
In any case, investors should always consider the tax implications of your investments. It can ensure that you have a good balance of retirement and non-retirement savings, and it can add percentage points to your annual returns.
