Money Sundays: Is Looking For Tax-Efficient Investments Icky? Or Intelligent?

Here's a comment from an anonymous reader in last week's post on investing and taxes that reveals a common error of logic I often hear from new investors:

I think you made it political when you assumed that reducing our tax burden as much as possible is a goal everyone shares.

I understand your point was how to increase one's own family's financial wellbeing by becoming more independent from wage income. But you are certainly making the assumption that paying less taxes is a good thing. Otherwise having the tax code "work for us" would be a rather irrelevant thing to say, and having a particular means of investment avoiding Medicare and SS taxes wouldn't be phrased as a perk.

Wrong wrong wrong wrong wrongity wrong.

Let's think it through. If I save some extra money from my wages, invest it into a dividend-paying stock, and then receive a dividend payment that happens to get taxed at the relatively low rate of 15%, am I paying less tax?

No, silly. I'm paying MORE tax. The government is going to receive extra tax revenue from me, thanks to this additional investment that I made. I make more, the government makes more. It's pure win-win. It just happens that the tax rate on this incremental money is 15%.

This reader's error is to confuse tax rates with aggregate tax dollars. This reader then leaps to the disempowering and even more incorrect conclusion that to make this investment is somehow an attempt to avoid taxes--when in reality it is the exact opposite.

This is a common and naive assumption many new investors make. Don't make it.

I want to make sure this concept is extra-extra-extra clear, so bear with me as I give one more example. Let's say you have $10,000 to invest and you are deciding between three possible investments:

1) A 10 year Treasury bond (currently yielding 1.6%) taxed at your 28% ordinary income tax rate.
2) A bank CD that yields 0.4% that will also be taxed at 28%.
3) A dividend paying stock, yielding 4%, taxed at 15%.

Trick question: which of these three investments will generate the most tax income for the US government? [Answer below*]

Do you see now?

One final point--and I hope our anonymous reader won't be offended as I use his or her comment to help others struggling with investing. Many, many people assume that seeking out attractive investments from a taxation standpoint is icky, or cheating, or somehow greedy.

Have you ever experienced these feelings? If you have, please know that they come from a combination of a simple logic error and a whole lot of scarcity-based thinking. This combination is toxic, because it needlessly separates you from your money... and it also separates our government from incremental tax revenues.

In fact, you can even flip this script and think of it another way: if you want to pay more in taxes, you should be making as many investments as you can.

Remember: if you save more money, invest more money and earn more money, you pay more in taxes, not less. Simple.

It is okay to seek out incremental income in addition to your wage income. I give you permission. Believe me, you won't "avoid" taxes like this reader thinks. You'll pay more in taxes. And you'll have more income as well.

None of this sounds very icky to me.

Readers, share your thoughts!

1) $10,000 invested in a 10 year Treasury at the current 1.6% yield would generate $160 in interest income per year. It would be taxed at 28%, generating $44.80 in taxes.

2) $10,000 invested in a bank CD at 0.4% would generate $40 in interest. Taxed at 28%, this generates $11.20 in taxes.

3) $10,000 invested in a 4% yielding stock would generate $400 in income. Taxed at 15%, this generates $60.00 in taxes.

Therefore, the dividend paying stock, despite having a lower tax rate, produces the highest tax revenues.

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Anonymous said...

As the original commenter...

Presumably you can see how all the talk of wage slavery and shackles could give me the wrong idea. It sounded like you were suggesting replacing your wage earning (and thus paying of higher taxes) with your investment return earning (and thus paying of lower taxes). If you're working the same amount but just also earning money from investments, fine, I retract. But that doesn't really relieve you from wage slavery in any way.

Daniel said...

Next time I'll be sure to assiduously avoid any words, phrases or visual metaphors that might possibly give you the wrong idea. :)

I'm joking. I can't possibly even know who you are.

Look, in the first steps of this process, you are right: the income is all incremental. But the goal in the medium to long term is to generate sufficient income from non-wage sources such that you can leave full-time traditional paid work. Uh, you know, retire. If you want.

For more on this, I strongly recommend the book Your Money Of Your Life, as well as my post Extreme Savings.

One last thought: if you save aggressively and are diligent about this process, you'll pay *plenty* of taxes. No need to lose sleep over that. Once again, do not confuse tax rates with aggregate tax dollars.


chacha1 said...

Thanks for the math, Dan. I'm not currently in the phase of seeking to maximize investment income (probably should be, but there are only so many things a person can concentrate on), but at least this helps confirm my bias toward stocks for long-term investments.

The only reason I'm putting *anything* in my bank money-market account, at a laughably low interest rate, is because I hope to yank it all out in 2-4 years via a big down-payment check.

Daniel said...

Good point Chacha. When you're saving up for a major expenditure, making an "investment" with that money (and thereby putting it at risk) may not be a good idea.

Sometimes you need to stash the money you're saving into a truly risk-free place--even though you are giving up some income on that money.


Little Old Les said...

what does the phrase "a whole lot of scarcity-based thinking" mean?

Your notuptodatewithcurrentlingooldsister :)

Daniel said...

Little Old Les: It means using zero-sum thinking.

In other words, if I get an extra dollar thanks to a lower tax rate on some investment, it must be true that somebody else (in this case the government) loses a dollar.

It's a great question and there's a lot of nuance embedded in it, so be sure to take a look at this upcoming Sunday's post. I'll flesh out this concept some more.