Debt Free Article
Top Ten Mistakes People Make When Investing
Mistake #6 (Part 1)
Focusing only on your return
When investing, many people hone in the return and leave out other important factors. Think of it like this – there is so such thing as a free ride.
The help you better understand investment return, read the following very helpful information:
Investment returns
The return on investments comes in the form of income, capital appreciation, or both. The total return on an investment refers to the sum of these components. Meaning, say you purchase a common stock for $100. After one year it produces $5 of dividends. The income return on the investment is $5/$100, or 5% - the current yield.
Now, at the end of the year, that stock is worth $107, it has appreciated 7%. This is the growth rate. The sum of these figures is - in this actual case, is 12%. That is the stock’s total return.
Depending on the type of investment you own, however, some or all of this return may be subject to federal and or state income tax. The amount you keep after paying taxes is called the after tax return. The tax rate is the combined federal and state tax percentage (stated as a decimal) that you pay on the return component on which you are focusing such as interest, dividends, and capital gains.
Worth mentioning: Your tax on long term capital gains, which applies to assets held for longer than 1 year, may be lower due to maximum federal tax rates ranging from 8-20%, depending on your regular tax bracket, applicable to such income. Additionally, the tax on the growth part of the return is deferred until the growth is recognized by selling the stack.
Generating capital gains could be one of your big opportunities to save on your taxes. With the current tax law changes (changes happen occasionally), the tax benefit of long term capital gains has again become substantial. The law updates in the recent years have created a 20% tax rate (10% for gains in the 15% bracket) on capital gains on investment assets held more than one year.
What’s more, the capital gains tax rate on the sale of assets held more than a 5 year term and which have been bought since the year 2000 have been reduced to 18% (or 8% for those gains in the lowest tax bracket regardless of when they were actually bought).
Should you incur losses from the sale of a capital asset, you could deduct those losses to the extent they equal capital gains from the sale of other assets. If these losses exceed your actual gains, you are only allowed to deduct$3,000 (half that if married and filing separately) of capital losses in a tax year against other income on Form 1040. You carry losses forward and continue to deduct $3,000 ($1500 for married filing separate) annually against other income until your losses are used up.
After tax return is an effective way of comparing two investments that are taxed differently.
When calculating after tax return, you should compare only bonds that are similar to each other in maturity and risk. So, you would not compare US Treasury bonds to tax exempt money market funds. Their maturities are different. Also, you would not compare an A-rated municipal bond to a US Treasury bond – they have different default risks.
Continued…
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