Taxes and Investing (Draft)

1. FIN 352 - Professor Dow Taxes and Investing (Draft)

2. The Lecture • Basic Investing Principles: • Be diversified. • Hold a portfolio with the appropriate level of risk. • Asset allocation determines risk and expected return. • Tax laws can change the relative returns of different assets. • This might affect how you invest.

3. Three ways taxes affect investing. • Some types of income are taxed differently. • Some assets are taxed differently. • Some accounts are taxed differently.

4. Some types of income are taxed differently • Capital gains vs. ordinary income. • Taxes on dividends. • Short-term vs. long-term capital gains.

5. Some assets are taxed differently • Mutual Funds • Municipal Bonds • Treasury Bonds

6. Some assets are taxed differently • Mutual Funds: • Mutual funds that realize capital gains through selling shares must distribute these gains (typically towards the end of the year). • Shareholders must pay taxes on these gains even if they did not sell any shares and the distributions are reinvested in the fund.

7. Some assets are taxed differently • Municipal Bonds: • Income from Municipal Bonds are exempt from Federal taxes and from state taxes if issued by that state. • Compare with similar corporate bonds by comparing after-tax yields. • Best for high-income (high-tax-rate) investors.

8. Some assets are taxed differently • Treasury Bonds: • Interest earned on Treasury bonds is exempt from state and local taxes. • Taxes still owed on capital gains. • Interest is not exempt from Federal taxes.

9. Some accounts are taxed differently • Retirement Accounts • 401k • Traditional IRA • Roth IRA • Other retirement accounts • Health and Education Accounts

10. Some accounts are taxed differently • 401(k) • Accounts are set up with employer. • Employer may contribute matching funds. • Individuals can contribute to their account each year with pre-tax money. • Taxes are not paid until the money is withdrawn. • Individually directed and can invest in most types of assets, although options may be limited by employer. • Limits on contributions plus various other restrictions.

11. Some accounts are taxed differently • Traditional IRA: • Individuals can contribute to their account each year with before-tax money. • Taxes are not paid until the money is withdrawn. • Individually directed and can invest in most types of assets. • Limits on contributions along with various other restrictions.

12. Some accounts are taxed differently • Roth IRA: • Contributions are made with after-tax dollars. • Income is not taxed. • Individually directed and can invest in most types of assets. • Limits on contributions along with various other restrictions.

13. Some accounts are taxed differently • Roth vs. Traditional: • Roth is taxed now while a traditional IRA is taxed at retirement. • Since tax rates at retirement are usually lower than while working, this is an advantage for the traditional IRA.

14. Some accounts are taxed differently • Roth vs. Traditional: • However, if you contribute the maximum, the Roth may be more valuable since the limit is in post-tax dollars. • There are other differences that can be important.

15. Some accounts are taxed differently • The Asset Location Decision: • Determining what assets go in which account is called the asset location decision. • Ideally, assets generating income subject to the highest tax rate should go in tax-sheltered accounts.

16. Conclusion • Tax laws can significantly affect your investment returns. • However, the rules can be complicated and can change each year, so be sure to do your homework.

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