Lower Taxes on your Investments

So you’d like to pay less tax on your investments.

Compound Taxes: Reinvesting Dividends and Capital Gains

Compound Interest Exposed: To reinvest or not to reinvest? Auto-pilot to mediocrity and failure? How much of your wealth will be transferred along the way? What if everything you believed to be true about this strategy turned out not to be true?

Have you ever paused to consider the fact that reinvesting dividends and capital gains can actually create a compound tax along with compound growth potential?
It seems that most people are familiar with the potential rewards of compounding the interest in their accounts, but few people are familiar with the tax ramifications that are associated with the same potential growth on these accounts. As the interest is earned, taxes can pile up pretty quickly.

Tax compounding is the most common problem with taxes that impact our nonqualified investments. Compound growth makes your money look like it grows on paper. It typically begins with a lump sum investment and includes regular amounts added to the account each year. Your account may also grow as the interest is earned or paid.
Many people continue to roll the interest earned right back into the principal balance of the investment account that continues to add to this compounding effect. The result is an ever increasing 1099 form and a corresponding increased tax that often goes unnoticed.

The government is a silent partner in this account. While they don’t take any risk in the actual account, they do participate in all of your gains. They throw a party every year and celebrate your wise investment decisions by confiscating a portion of your gains.

While you spend your time focusing on finding the right rates of return and the best places to put your money, they’re counting on the taxes due on their end. It is true that your interest is compounding, but at the same time, so is the tax due in the future. What happens when you go to distribute that money? You will likely face a huge tax bill. Sometimes compounding can even increase your risk. The longer you compound your account, the more likely it becomes that future market corrections may impact your nest egg. Compounding works best in an environment that works in connection with other separate accounts that are growing in tax-free (or tax-favored) instruments.

It is widely accepted that compound interest is the eighth wonder of the world. Not to reinvest dividends in capital gains has been viewed as insanity. Unfortunately, much of what is popular and promoted by the investment community is the exact opposite of what most people should do. While reinvesting dividends in capital gains can give you the opportunity to accumulate wealth, it is also true that it causes some new taxes. It’s taxed while it’s growing and as it continues to grow to a larger figure. As this occurs, your incremental taxes will grow along with it.

If we follow this line of logic then it must also stand to reason the ninth wonder of the world would be compound taxes. We can help you uncover some of these hidden costs so that you may make more informed decisions about where and how to grow your money. It’s important to understand that an investment with compounding taxable interest also has a defined cost. The taxes on the gains represent a cost to maintain your investment regardless of where that tax comes from.

Many people reinvest their investment earnings into their investment accounts. As they do this, they end up paying additional taxes each year out of their personal cash flow. At some point in the future, taxes due can actually exceed their annual income.

Very few people pay the taxes due on their investment interest gains from the principal balance. It often comes from another source, which we call cash flow. The taxes due from these investments are hidden in the details of their overall tax picture, and therefore often go unnoticed each year unless someone else, such as a professional, points it out.

It is easy to focus on the amount we have in our accounts. Some of these gains are real, but others are only apparent. What if in order for you to accumulate that amount in your left pocket, you had to reach into your right pocket for the taxes due on your gains? You would have to account for these taxes in your net profit calculation. Most people end up paying more taxes than they have to.

In order to draw a fair comparison between investment strategies, we must account for the costs associated with growing our capital. These include both taxes and opportunity costs. When you take the money from your investment account to pay a tax that could have been avoided, it includes both the tax and what the tax money would have earned for you had you been able to hold onto them and continue to invest them.
Most people don’t want to pay more taxes. Generally, people prefer to avoid the taxes if they knew how. Whenever you end up paying a tax that could have avoided, you give up the tax, as well as the opportunity cost on that money. These taxes must be viewed as a maintenance fee or cost for your investment. The investment gain creates taxable income that is reported to the government in Form 1099.

How Do We Solve This Problem?
A simple concept called netting comes into play. Take a look at the Alternate Strategy example. Instead of blindly reinvesting dividends and capital gains, or the interest from our CDs and other fixed accounts, what if we had that interest deposited into an accumulation account where we could make decisions with it at the end of the year? We might be in a much better position. Then we would have the power of choice. Depending on where our incomes come from and how the financial markets are performing, you may have more options for successfully avoiding future tax traps.

This is a simple concept. Interest gains will be reported on a 1099 tax form. Initially, the appropriate tax amount should be set aside for the IRS. However, the balance should not be blindly reinvested, but should be given consideration to whether it should be directed to a different investment that may have additional tax benefits . . . or to pay down debt if your debts carry a higher rate.

There are a few options that usually make sense to consider. There are benefits and drawbacks to each of these options, but a great place to start might be looking into Roth IRAs, real estate investments, municipal bonds, and dividend paying permanent life insurance.

Flattening the tax is the first step. The second step it reducing or eliminating the taxes due over a period of time. By slowly distributing the capital base over a period of time, we are able to reduce the amount of taxable interest earned. What if we drew our accounts down at the rate of 5 percent of the principal per year and repositioned those assets into a tax-free environment? In this example, it would take us about 20 years to drain the capital (taxable) base and migrate those assets into a tax-free environment. Our liquidity would not change much as the transfer would be very gradual in nature. This strategy would likely eliminate more of the future taxes due on our accounts.

Basically, we would move 5 percent of the taxable left pocket asset, to the tax-free right pocket. Over a period of 20 years, you would effectively move all of this account out of the tax picture without impacting much liquidity. If liquidity is not a big concern, this can be accomplished in a much shorter period of time. If 5 percent is too much to move, consider moving the interest gains only at first.

Imagine if all of your interest and future gains could accumulate tax-free? What would prevent you from incorporating this strategy into your plans?

From Ivy League Wealth Secrets by Keith R. Soltis
Learn more at www.ivyleaguewealthsecrets.com