What is tax planning?
Tax planning usually involves strategies to minimize your income tax liability by, for instance, deferring income, maximizing deductions and deductible expenses for a particular year, and selecting tax-advantaged investments.
Selecting investments from a tax perspective
Investment tax planning focuses on the income tax implications of your investment selections. You should understand how the different returns of the investments you are considering are taxed before finalizing your asset allocation decisions. For example, corporate and most government bonds generate ordinary income taxed at your marginal (top) tax bracket. However, municipal bonds are generally tax exempt. The stocks of many large, established companies like banks and utilities pay regular dividends. Dividends are eligible for a reduced rate of tax from 2003 – 2010. Otherwise, dividends are taxed as ordinary income. Many growth companies, such as technology firms, pay little or no dividends, as they reinvest all their earnings. Most stock is owned in the hope that it will increase in value over time. This increase in value is called a capital gain, and is most often taxed at a lower rate.
The timing of when you receive income is also an important consideration. Taxable bond income and dividends are taxed in the year you receive the income. The increase in the value of a stock (capital gain) is generally taxed when the stock is sold. Either way, timing should be taken into consideration if you decide to make a major shift in your investments that requires the sale of a large amount of highly appreciated assets. It is also important to know that stocks you hold for one year or less will not receive favorable tax treatment, and their gains are taxed as ordinary income.
The investment strategies of mutual funds should also be considered from a tax perspective. Some funds adopt a buy-and-hold strategy that minimizes the tax generated. Other funds regularly buy and sell investments, triggering taxes even if you do not make any changes to your investments.
Additionally, when you are saving for retirement, you may choose to invest in tax-deductible and tax-deferred vehicles such as your 401(k) through your employer or an IRA or Roth IRA.
The process of selecting investments should not be based solely on tax implications, as each investment choice may have its drawbacks. Generally, if your tax objective is to select tax-favorable investments, it should be consistent with your return rate expectation and risk tolerance, overall goals, and time horizon.
