Too many investors believe that investing for income is not tax efficient.
They're wrong, and here's why.
The conventional wisdom points out that when you receive investing income, you have to pay taxes on it and at the ordinary tax rate (the same as you do for earned income).
If you hold stocks for a year or more, then sell for a profit, you must pay taxes at the long term capital gains rate, which is generally lower than ordinary income. The exact rates vary depending on the law currently in effect. Now in 2010 it's 15% for most taxpayers, though that will go up in 2011.
Now, you can choose not to pay this tax, by not selling the stock, but then what money do you have to spend? None.
Stocks that Pay Dividends Reward You for Owning Them
Unless that stock pays a dividend distribution. Then you are receiving cash in exchange for owning it.
Another good example of poor tax efficiency is mutual funds. Most people don't understand this, but when your mutual fund manager sells stock during the year for a profit, you must pay capital gains taxes on this. This is true even if, at the end of the calendar year, the fund's share value is far below what it was on January 1.
Yes, you can own a mutual fund, not sell any of the shares, lose money, and yet have to pay an extra tax bill for it.
Doesn't seem fair, does it?
Mutual Funds Contain Tax Dangers People Don't Understand
But it gets even worse. To owe that tax, you have to be owning the fund's shares as of a date late in the year, usually in November. If you sell the shares prior to that date, you don't owe the taxes.
That means that if you still own the shares in November, you have to pay the taxes for the people who owned shares earlier but bailed out before November. In effect, you have to pay their share of the capital gains distribution tax.
What's even worse, this is true even if you don't buy those shares until right before that date. If you buy the shares on November 1, you wind up paying the capital gains taxes for people who sold their shares before you bought.
Mutual Fund Owners Must Make Quarterly Goals, Not Save You From Paying Too Many Taxes
If your mutual fund manager sells stock the fund has held for under a year, that's a short term capital gain you must pay taxes on at the ordinary rate. If they held the stock a year or longer, it's a long term capital gain. You may well have some of both.
On average, mutual funds these days have a 100% turnover. They buy and sell all their stock in a year, on average. That's crazy. Make no mistake about it - that costs you a lot of future investing profits. Even if you have the capital gains distributions reinvested, you still must pay the taxes, and that's cash out of your pocket one way or the other.
Mutual fund managers buy and sell with flagrant disregard for the tax consequences to the fund share owners.
John Bogle found that, because of this, it was more tax efficient to keep mutual funds in tax-deferred accounts and income producing investments in taxable brokerage accounts, even though that goes against the common wisdom.
Personally, I recommend you avoid investing for capital gains in a taxable or tax-deferred account. It always makes the most sense to go for income first, second and last -- if at all possible.
If you never sell a stock, you never have to pay capital gains taxes. That's partly why I recommend investing for income.
Author Information: You too can benefit from investing for income retirement and taxable accounts. Click here to get the information you need to effectively make money from your investments whether the markets go up or down. If you're ready to discover how investing for income can help you retire with financial security, visit this page, enter your email address into the form and click on the Submit Button. Then go to your inbox and verify that. It's free for the taking. http://www.incomeinvesthome.com/.
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