Understanding tax strategies and managing your tax bill are an integral part of a sound financial approach. Conversely, ignoring the tax ramifications of your investment portfolio may result in lower overall performance. Some taxes can be deferred, and others can be managed through tax-efficient investing. With a careful and consistent preparation, you can potentially reduce the impact of taxes on your overall investment returns.
Taxes are a part of life. The average federal refund check for the 2013 tax year, was $2,755.Just over 110 million returns qualified for a federal refund for the 2013 tax year. Put another way, the federal government wrote checks totaling nearly $302 billion for tax payers.
More than likely, if you are interested in tax strategies, you didn’t get any money back from the federal government for 2013. In fact, there is a high probability you may have sent the Treasury Department a check.
It’s not necessary to have a comprehensive understanding of the tax code—and the thousands of pages of federal tax regulations that back them up. But to manage the impact of taxes, it’s critical to understand certain principles. A study by Morningstar, Inc., showed that during the 85-year period ended in 2011, investors who did not manage investments management
in a tax-sensitive manner lost between one and two percentage points of their annual returns to taxes. That means that a hypothetical stock return of 9.8% shrank to 7.7% after taxes.
Morningstar’s research was compiled to illustrate the potential impact of taxes on investment performance. Past performance does not guarantee future results. This is a hypothetical example used for illustrative purposes only. It is not representative of any specific investment or combination of investments. Stocks are represented by the Standard & Poor’s 500 Composite Index (total return), an unmanaged index that is generally considered representative of the U.S. stock market. Individuals cannot invest directly in an index.
Morningstar calculated the federal income tax by using the historical marginal and capital gains tax rates for a single taxpayer earning $110,000 in 2010 dollars every year. Annual income was adjusted each year using the Consumer Price Index (CPI), which is considered representative of overall U.S. prices at the consumer level. CPI adjustments were used to adjust the income level for each year. Income was taxed at the appropriate federal tax rate when it was taken. When realized, capital gains were calculated using the appropriate capital gains rate. For stock prices, the holding period for capital gains tax calculation is assumed to be five years. No state taxes were included in the calculation. Stock prices will fluctuate in value over time.