Four Tax Realities Every Investor Should Know

Executive summary:

  • Investment taxes can have a real impact on a portfolio
  • Investors should be aware of four key tax realities they currently face
  • Without a plan to manage these taxes, investors may find their ability to retire comfortably could be compromised
  • The impact of these tax realities can be mitigated

It's important to stay realistic. Sounds obvious, like the advice mom or dad would give us in our younger years. But let's be real – Real-istic! Sometimes, distinguishing between what is real, and what is realistically attainable can be quite challenging. As such, many individuals – and in the context of this article, investors – are either un-realistic or think about things in an alternate reality. Taxes are real, and they have a real impact on portfolio wealth. For most investors, trying to sidestep the tax issue without a well-thought out strategy remains an elusive aspiration. Let's take a look at Four Tax Realities to see which taxes are real and have a real impact, and therefore where we should practically direct our attention.

1. Most interest is taxed

Absolutely, interest income falls under the umbrella of taxable income. Even when it's labeled as "Tax Free Interest", there can still be some tax implications. You might be aware of this if you’re a financial professional, but here's the reality—many investors don't always know that interest from bank accounts, money market funds (MMFs), and certificates of deposit (CDs) are all taxable as income.

Moreover, most bond interest is taxable as income. Depending on the type of bond, various tax levels may come into play, and in some cases every tax level is involved. Consider these examples:

  • Tax Free Municipal Bonds escape Federal income taxes and often local income taxes if the investor resides in the bond's state of issue.
  • Treasury Bonds are exempt from state and local income taxes but are subject to Federal income taxes.
  • Corporate Bonds’ income faces taxation at Federal, State, and Municipal levels
  • Private Activity Municipal Bonds avoid Federal income taxes but may be subject to taxation under AMT rules – a potential concern for higher-income earners.
  • Non-US bond interest is generally fully taxable in the U.S., with foreign taxes, withholding rules and additional record-keeping potentially entering the picture.

Since interest income is typically taxable, it's imperative to factor in the tax cost. In our current inflationary environment, it's equally vital to acknowledge the impact of inflation on the spending power of after-tax interest income.

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