Understand the Tax Implications of Financial Decisions

The Internal Revenue Code is a very complex and often confusing set of rules. Individuals sometimes let tax issues cloud their decision-making. Here are three areas where some simple reminders can help you make wiser financial decisions:

The income tax rate structure

Our marginal tax rate structure generally means that income at lower levels is taxed at lower rates than income at higher levels. There are complex rules about how to calculate taxable income, taking into account deductions and exemptions. The 2001 tax law started to bring rates down and the 2003 tax law change accelerated that reduction. The tax rates start at 10% and go up to 35%. Below are tax tables for 2009.

Taxes on capital gains and dividends compared to regular taxes

Gains on the sale of most investments held more than one year usually receive favorable tax treatment. The top tax rate for most long-term capital gains is now 15%, compared with a top tax rate of 35% on other income for 2009. If you are considering selling a stock at a gain that you have held for almost 12 months, consider waiting for the full 12-month period to lapse. But remember, waiting means you are still subject to market fluctuations.
Under the 2003 Tax Act, most dividends from investments will now be taxed at the same rates as capital gains. For individuals with relatively large amounts of dividend income, this could represent a significant tax reduction.

Taxable vs. tax free bonds

Those in higher tax brackets often benefit from tax-exempt interest income. To see if you should consider tax-exempt bonds, compare the after-tax yield of a taxable bond to the yield of a tax-exempt bond. To calculate the after tax yield of a taxable bond you can use the following formula:

For example, here is the equation to calculate the after tax yield of a taxable bond with a yield of 6% for someone in the 35% marginal tax bracket.

AFTER TAX YIELD = 6% - (6% X .35)
                            = 6% - (2.1%)
                            = 3.9%

Or, you can use the following table:

The tax brackets are those in effect in 2009.

Remember, to get a true comparison it is critical that the taxable and tax exempt bonds have similar maturity dates and similar quality ratings.

According to the chart, a tax-exempt bond yielding 4.0% has an equivalent after-tax yield of 6.0% for someone in the 33% tax bracket. For that person, a taxable bond yielding more than 6.0% will produce a better after tax return.

Final Words
Taking time to understand how the tax laws apply to your financial situation will enable you to make more informed decisions. You should always consult your tax advisor to determine how the rules apply to your situation and remember that state income taxes must be considered.