David Ashby: How You Invest Your Money Matters | Opinion


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It’s a phrase you often hear in connection with real estate. But it could also apply to the world of investments.

Suppose you have two different financial accounts for investing. The first is a traditional IRA in which you make deductible contributions each year for a retirement fund. Any income earned in this account is deferred until you withdraw the funds.

The second account is a regular investment account, or taxable account. Income earned in this account goes into your personal income tax return at the end of the year. And you don’t get a tax deduction for contributing to this type of account.

Now suppose you are considering buying two investments: a Murphy Oil bond paying five percent interest and Murphy Oil common stock currently trading at $ 25 and paying a dividend of 50 cents per year. Which account holds which investment does it matter? You bet it does and let’s see why.

When you withdraw funds from your Traditional IRA, these distributions will be taxed at regular tax rates. Depending on your income level, these rates can reach 37% at the federal level. Next, calculate another 6 percent maximum for Arkansas income tax. (As a side note, the first $ 6,000 of retirement income is exempt from tax in Arkansas.)

Suppose I place the Murphy stock in my IRA account. I buy the stock at $ 25 and years later it is trading at $ 45. So I sell the shares and withdraw the funds from the IRA. What I have described here is long-term capital gain, an investment that has been held for over a year. And long-term capital gains rates are significantly lower than regular income tax rates, peaking at 20% at the federal level and effectively 3% at the state level.

But don’t forget this comment about distributions from an IRA that are taxed at regular tax rates. So even though my Murphy’s stock gain looks and feels like a long-term capital gain, it doesn’t get a capital gains tax rate because of the type of account it’s held in.

But if I had held the shares in my taxable account, the $ 20 gain would have qualified for long-term capital gains tax. In addition, this 50-cent dividend, if it meets certain holding period criteria, is also eligible for capital gains tax if it is held in the taxable account. But that too will come out as ordinary income if it is held inside the IRA.

Now suppose that instead of putting Murphy shares in my IRA, I buy the Murphy bond in the IRA account. Interest on corporate bonds is taxable at the federal and state levels at ordinary income tax rates. So interest on the Murphy Bond will be taxed at regular rates whether I hold it in the IRA or in the taxable account. The difference is that in the IRA, I don’t pay taxes until I withdraw the funds. In the taxable account, I have to pay interest taxes every year.

I realize that this discussion can create a nerve-racking puzzle for you. But considering that most of us must hold a combination of stocks and bonds in our portfolio, this process of locating assets can result in significant tax savings. Research from mutual fund giant Vanguard estimates that good asset tracking practices can add up to three-quarters of a percent to after-tax returns.

Considering that the national average rate on one-year CDs is currently around half a percent, that’s a big savings!

Dr. David Ashby is a Chartered Financial Planner and a retired People’s Bank Finance Professor at the University of South Arkansas. He holds degrees in accounting and business administration and a doctorate in finance from Louisiana Tech.

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