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How can I lower my taxes?
Question: I’m tired of paying so much in taxes. What investments will lower my taxes?
The Mole’s Answer: I am frequently asked this very question. And though it seems absolutely logical, it’s really not the right question to ask. The better question would be how you can increase your earnings after paying taxes.
I often have clients come in with investments that their previous adviser put them in which successfully lowered their taxes, as if that were the goal. As is typically the case, it also lowered their after-tax return. Let’s first look at a couple of examples and then talk about how you can increase your after-tax earnings.
Municipal Bonds
A “muni” bond is issued by a state, county or municipality and the holder of these bonds doesn’t have to pay federal taxes. In some cases, they are also state tax-exempt. That certainly would lower your taxes, but still may not be the right thing for you.
As of the time of this writing, a five-year AAA rated muni bond paid an average of 2.92%. That means a $10,000 investment would yield $292 annually, with nothing going to Uncle Sam!
But an equivalent, five-year AAA taxable bond averaged a 4.46% annual return, or $446 before any taxes. A taxpayer in the 25% marginal tax bracket would have to pay $112 in taxes. Still, even after the tax bill, this bond would leave $334.
So the bottom line is that the muni bond did save $112 in taxes yet, after all was said and done, also yielded the investor $42 less than the taxable bond. A tax payer would have to be over the 35% combined tax bracket for the muni to make sense.
When I go through the math with a client, they typically tell me the planner who sold it to them said it would be easy to get out of. That’s when I get to deliver the news that, actually, these muni bonds rarely trade, and you often have to pay what’s called a spread of 2% to 3% to get out. That happens to be one of those hidden costs you’ll never see.
(for the next example, take the link below)
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