A few weeks ago I was in Shanghai and, due to the glories of jet lag, I woke up at midnight and couldn’t go back to sleep. Given that I had about 10 hours before I needed to be at a customer site I decided to try to be productive.

So there I was – sitting at the desk of my hotel room reading the income tax section of my textbook to prep for the CFP test in July. I had my back to the window (trying to ignore the awesome view of a very cool city). I was reviewing the details of the importance of making all investment decisions on an after-tax basis. Anybody reading this site already understands this idea – taxes affect every investing and saving decision we make. If you want to compare the return of two investments you have to look at the after-tax return.

For example, I often see other bloggers (and even professional investment advisors) talk about the yields of REITs. And yes, the yields of REITS are high, but there’s a catch – REIT income is taxed as regular income. Dividends and long-term capital gains are taxed at special rates of either 0% (if you’re in the 10% or 15% marginal tax brackets), 20% (if you’re in the top tax bracket), or 15% (everybody else).

This has the effect of dramatically narrowing the difference between REIT income and income from regular dividend stocks.

Let’s walk through an example using two of my favorite investments: Omega Healthcare Investors REIT (OHI) and Johnson & Johnson (JNJ). The yield on OHI is 7.8% and the yield on JNJ is 2.55%

To calculate the after-tax return you just multiply your return by (1 – the tax rate). So if you’re in the 35% tax bracket (15% for dividends/long-term capital gains) your returns are:

OHI after-tax yield = 7.8% * (1-.35) = 5.07%

JNJ after-tax yield = 2.55% * (1-.15) = 2.17%

While the yield from OHI is certainly still higher, it’s gone from being 3.05x higher before taxes to 2.33x higher after taxes.

Ok, so back to my story. There I was, reviewing tax calculations and phaseouts of deductions, comparison of tax rates, etc. when I realized I was making a huge mistake with my cash.

What’s a sweep account?

When you place an order to sell a stock the proceeds are automatically deposited by your broker into your sweep account. Any dividends you receive that aren’t automatically reinvested are also deposited into your sweep account.

Most brokers allow you quite a bit of flexibility in determining what your sweep account is. The default sweep account is invested in a money market fund. For those who don’t know, money market funds are designed to be extremely stable and liquid. They invest in high-quality short-term debt (government and corporate bonds, etc.)

Right now all my taxable investments are in my Vanguard account. The default sweep account for my Vanguard account is the Vanguard Federal Money Market Fund (VMFXX). The “SEC Yield” (defined as the average yield over the last 7 days) is .73%. That’s not great, but given today’s ultra-low interest rate environment and the stability provided by the money market fund it’s not too bad either.

Unfortunately, that .73% yield is taxable income. Again, this is something I rarely see discussed when comparing different investments – bonds and other interest income is regular taxable income (taxed at your normal marginal tax rate) rather than at the much more advantageous long-term capital gains or dividend rate.

At that time I had exactly $43,464.46 in my sweep account. Assuming the .73% yield, that works out to $317.29 per year in interest.

Of course, that number is pre-tax. What does that work out to be after taxes?

I expect to be in the top tax bracket this year. If you combine the top Federal tax bracket (39.6%) with the top California tax bracket (13.3%) and the Medicare surcharge of .9% on incomes over $250,000, you have a top tax rate of 51.9%.

But the taxes don’t stop there!

Even MORE taxes

Another thing a lot of people don’t realize is that your itemized deductions start to get phased out once your income exceeds $311,300 for married or $259,400 for single filers. Each dollar of income that exceeds the threshold reduces your itemized deceptions by $.03, up to a maximum of an 80% reduction of your itemized deductions.

This is, essentially, an additional 3% tax on income, but only if you itemize deductions.

Similarly, your personal exemptions are subject to a phaseout if your income exceeds $305,050 for married and $254,200 for single filers. The exemption is phased out at a rate of 2% for each $2,500 of income beyond these limits.

Thus, the total taxes for high-income earners are:

39.6% Federal

13.3% California

.9% Medicare surcharge

3% Standard deduction phase-out

2% Personal exemption phase-out

Total marginal tax rate = 58.8%

We can now calculate the after-tax return on the taxable money market fund I was using:

After tax percent return = .73% * (1-.588) = .30%

After tax dollars = $43,464.46 * .30% = $130.72

That’s better than being punched in the face, but it’s painful to lose over 58.8% of your investment to taxes.

That’s when I realized that I needed to move this money into a tax-free account.

The switch to a muni fund

It took about 60 seconds of research to determine that the Vanguard California Municipal Money Market Fund (VCTXX) was a better option for me. The fund invests in California muni bonds, and since I live in California that means that all interest from the fund is tax-free.

The yield is .64% compared to the taxable Federal Money Market Fund yield of .73%.

Assuming the .64% return, I should receive $43,464.46 * .64% = $278.17 in tax-free interest for the year. That’s a solid 113% ($140.45) higher return than what I was receiving with the taxable money market fund.

With one minute of work I was able to more than double my after-tax return.

The amount of money at stake in this example is small – a few hundred dollars on a $43k cash reserve. However, this is free money, with absolutely no downside. The money is just as liquid as it was before – I’m just earning a better after-tax return. And, given that I’ve been advocating building a cash reserve to take advantage of future market opportunities, optimizing returns on the cash is a pretty important consideration.

 

Conclusion

The more money you make the more important taxes are to your investing decisions. In addition, taxes are more than just marginal tax rates – you need to consider the phaseout of exemptions, deductions, and credits when calculating the effect of taxes.

Readers: Have you ever realized you were leaving a lot of money on the table because of a simple oversight?  How much do you consider taxes before making an investment or other financial decision?