Take Advantage of Low Taxes on Investments

Updated: September 1, 2015

How can you take advantage of dividend and capital gain tax rates at historically low levels?

Sensible Financial™ identifies 4 specific strategies you can use to maximize your benefit.

The 2003 tax law1 reduced the tax rate on capital gains from 20% to 15%2. In addition, the treatment of dividends changes – once ordinary income, with tax rates as high as 39%, you now pay taxes on these returns at capital gains rates. This sounds like an unmitigated benefit. Who doesn’t like to pay less in taxes?

The mitigation is that these benefits are scheduled to last only five years or so, terminating December 31, 2008. Sensible Financial knows of no way to predict whether they will continue beyond that date or not. However, we’ve designed the advice below to be effective even if the reductions don’t continue.

How can you take the fullest advantage of reduced tax rates? Aside, that is, from smiling a bit when you file your 1040 next April, as you say to yourself, “I saved $100 (or pick your number) because tax rates are historically low.”

Not surprisingly, the actions we recommend have to do with moving assets into situations where their earnings pay taxes at the lower rate. And, that requires moving them out of other investments where the costs are now relatively higher.

“Buy and hold” and “value” investing strategies are more attractive for your taxable accounts

The advantages of “tax-advantaged vehicles” are less

If taxes are less, then so are tax advantages. In some cases, the “tax advantages” actually have become negative. And, for some “tax-advantaged” vehicles charging extra fees, the fees have become much more likely to swamp the “tax advantages”.

The economics of your mortgage have changed ever so slightly

Your new tax rate is probably slightly lower than previously. As the following chart illustrates, rates have declined by 2 or 3 percentage points, depending on your taxable income. If you have a mortgage, this means that your after-tax cost of borrowing has gone up slightly. If your mortgage interest rate is 6%, your after-tax rate is now .12% to .18% higher. If your mortgage interest rate is 5%, your after-tax rate is now .10% to .15% higher.

For example, if you were in the 27% bracket, and are now in the 25% bracket, your 6% mortgage was costing you 4.38% after-tax, and now costs 4.5% after-tax.

Compare this to the after-tax economics of investing in equities that we mentioned above, where expected investment returns on growth equities are unchanged at around 7%, and expected returns on value equities have improved from 5.2% to 6.6%.

You may have heard that paying of your mortgage gives you a guaranteed return, and it does. Your return is the after-tax interest rate. The tradeoff has changed: paying off your mortgage is now a slightly better deal, investing in value equities after tax is now a significantly better deal.

Summary

The implications for you of this tax rate environment depend on many factors, and it may be worth thinking through your options. Sensible Financial is ready to help. Give us a call if you’d like assistance in creating a solid plan of action.