Interest you receive from bank accounts and corporate bonds is generally
taxable. U.S. Treasury bonds pay interest that’s state-tax-free. Municipal
bonds, which state and local governments issue, pay interest that’s federaltax-free and also state-tax-free to residents in the state where the bond is
issued.
Taxation on your capital gains, which is the profit (sales minus purchase
price) on an investment, works under a unique system. Investments held
less than one year generate short-term capital gains, which are taxed at your
normal marginal rate. Profits from investments that you hold longer than 12
months are long-term capital gains. These long-term gains cap at 15 percent,
except for those in the two lowest tax brackets of 10 and 15 percent. For
these folks, the long-term capital gains tax rate is just 5 percent.
Use these strategies to reduce the taxes you pay on investments that are
exposed to taxation:
✓ Opt for tax-free money markets and bonds. If you’re in a high enough
tax bracket, you may find that you come out ahead with tax-free investments. Tax-free investments yield less than comparable investments
that produce taxable earnings, but because of the tax differences, the
earnings from tax-free investments can end up being greater than what
taxable investments leave you with. In order to compare properly, subtract what you’ll pay in federal as well as state taxes from the taxable
investment to see which investment nets you more.
✓ Invest in tax-friendly stock funds. Mutual funds that tend to trade less
tend to produce lower capital gains distributions. For mutual funds
held outside tax-sheltered retirement accounts, this reduced trading
effectively increases an investor’s total rate of return. Index funds are
mutual funds that invest in a relatively static portfolio of securities, such
as stocks and bonds (this is also true of some exchange-traded funds).
They don’t attempt to beat the market. Rather, they invest in the securities to mirror or match the performance of an underlying index, such as
the Standard & Poor’s 500 (which I discuss in Chapter 5). Although
index funds can’t beat the market, the typical actively managed fund
doesn’t either, and index funds have several advantages over actively
managed funds. See Chapter 8 to find out more about tax-friendly stock
mutual funds, which includes some non-index funds, and exchangetraded funds.
✓ Invest in small business and real estate. The growth in value of business and real estate assets isn’t taxed until you sell the asset. Even then,
with investment real estate, you often can roll over the gain into another
property as long as you comply with tax laws. However, the current
income that small business and real estate assets produce is taxed as
ordinary income.
Short-term capital gains (investments held one year or less) are taxed at your
ordinary income tax rate. This fact is another reason that you shouldn’t trade
your investments quickly (within 12 months).
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