THE BEECHMONT CREST ONLINE GUIDE TO STOCKS AND INVESTING
Reducing tax liabilities
When evaluating one’s tax liabilities, it is important to distinguish between marginal tax rate and average tax rate.
The marginal tax rate is the portion of each additional dollar of income that will be paid in taxes. The marginal tax rate can be thought of as the change in one's tax liability as income rises.
The marginal tax rate can be represented mathematically as:
The average tax rate is total tax liability divided by the total income. This is the average amount of taxes that an individual pays for each dollar earned.
The average tax rate can be represented mathematically as:
Tax reduction strategies
Government bonds, etc.
Many investors reduce their tax liabilities by investing in federal securities (Treasury bills, bonds, and notes). The interest received from federal instruments is exempt from state taxes.
Likewise, the interest received on state and municipal instruments is exempt from federal income taxes. Interest on these instruments is also typically exempt from taxes in the state and/or municipality of issuance.
The tradeoffs between a tax-exempt municipal investment and a taxable non-municipal investment can be calculated using the following formula:
Equivalent yield of taxable investment = municipal yield / 1 – marginal tax rate
To illustrate, suppose that an investor has a marginal tax rate of 25%. A taxable investment with a yield of 6% has an after-tax yield of:
6% x (1 - 0.25) = 4.5%
This means that a municipal investment with a yield of 4.5% offers the same after-tax benefit as a taxable investment with a yield of 6%.
Contribution to an IRA (individual retirement account)
IRA contributions are tax-deductible if certain requirements are met. The IRA was originally developed in 1974. Today there are multiple types of IRAs to choose from.
The Roth IRA was created by the Tax Reform Act of 1997. The Roth IRA has a tax structure that many investors find advantageous.
The disadvantage of IRA accounts is that funds invested in these accounts cannot be withdrawn until retirement age without a penalty. Certain exceptions apply---such as withdrawals for educational expenses---and vary according to the law.
Contribution to a 401K plan
Many employers allow employees to make tax-deferred investments in a 401K plan. These are often matched by employer contributions up to a certain limit.
401K plans are therefore especially advantageous, as they enable an investor to double a portion of her investment on a tax-deferred basis.
Money invested in 401K plans is also subject to a penalty if withdrawn prior to retirement age.
Tax reduction strategies and age
The average twentysomething investor is already in a low tax bracket. Therefore, investing heavily in government securities would probably not be a good strategy, as government securities have low returns.
However, young investors should invest in tax-deferred retirement plans such as IRA and 401Ks.
Many older investors see their marginal tax rate decline upon retirement. For these investors, tax avoidance is not the major concern that it once was. Municipal instruments therefore lose one of their major advantages.
