Understand the real returns of your investments
Investing in financial instruments such as money market CDs, short-term Treasuries or high-yield savings accounts with a 5% yield may seem profitable. However, investors need to understand what they actually receive after taxes. The tax bracket an investor falls into has a significant impact on their after-tax returns.
For example, if an investor is in a 24% tax bracket, their after-tax return would be 3.8%. If they fall into a 32% tax bracket, their after-tax returns would be 3.4%. And if they are in the highest tax bracket of 37%, their after-tax returns would be 3.15%.
The impact of state taxes on your returns
The state in which an investor resides can also have a significant impact on his or her after-tax returns. For example, if an investor lives in New York, the highest tax bracket adds an additional 10.9% to their taxes, bringing their after-tax returns to 2.6%.
In California the situation is even more dire. The highest tax bracket adds an additional 14.4% to an investor’s taxes, bringing his or her after-tax returns to just 2.43%.
The risk and return of cash investments
Cash is often considered a risk-free asset. However, a risk-free asset will always underperform risky assets over time. This is because risky assets, such as stocks and bonds, have the potential to earn higher returns to offset their higher risk.
Over the past decade, cash has underperformed every major asset class except commodities. This means that if an investor had invested his money in almost any other asset class, he would have achieved higher returns than if he had kept his money in cash.
The futility of timing the market
Many investors try to time the market in an attempt to maximize their returns. They try to buy when prices are low and sell when prices are high. However, this strategy is often unsuccessful.
Market movements are unpredictable and influenced by many factors, many of which are beyond the control of the individual investor. Therefore, trying to time the market is often a futile effort.
Instead of trying to time the market, a better strategy is to invest consistently over time. This approach, known as dollar-cost averaging, reduces the risk of making a large investment at the wrong time. It also allows investors to take advantage of the market’s long-term upward trend.
Conclusion
Ultimately, investors need to understand the actual after-tax returns on their investments. The state they live in and their tax bracket can have a significant impact on their after-tax returns.
Cash may seem safe, but over time it underperforms risky assets. And while it can be tempting to try to time the market, a more effective strategy is to invest consistently over time. By understanding these principles, investors can make more informed investment decisions and potentially increase their returns.
Frequent questions
Q. What impact do tax brackets have on investment returns?
The tax bracket an investor falls into has a significant impact on their after-tax returns. For example, if an investor is in a 24% tax bracket, their after-tax return would be 3.8%. If they fall into a 32% tax bracket, their after-tax returns would be 3.4%. And if they are in the highest tax bracket of 37%, their after-tax returns would be 3.15%.
Q. How do state taxes affect investment returns?
The state in which an investor resides can also have a significant impact on his or her after-tax returns. For example, if an investor lives in New York, the highest tax bracket adds an additional 10.9% to their taxes, bringing their after-tax returns to 2.6%. In California, the highest tax bracket adds an additional 14.4% to investors’ taxes, bringing their after-tax returns to just 2.43%.
Q. What are the risks and returns of cash investments?
Cash is often considered a risk-free asset. However, a risk-free asset will always underperform risky assets over time. This is because risky assets, such as stocks and bonds, have the potential to earn higher returns to offset their higher risk. Over the past decade, cash has underperformed every major asset class except commodities.
Q. Why is market timing often a futile effort?
Market movements are unpredictable and influenced by many factors, many of which are beyond the control of the individual investor. Therefore, trying to time the market is often a futile effort. Instead of trying to time the market, a better strategy is to invest consistently over time. This approach, known as dollar-cost averaging, reduces the risk of making a significant investment at the wrong time. It also allows investors to take advantage of the market’s long-term upward trend.
Q. What is the importance of understanding actual investment returns?
It is important for investors to understand the real after-tax returns of their investments. The state they live in and their tax bracket can have a significant impact on their after-tax returns. Cash may seem like a safe investment, but over time it underperforms risky assets. And while it can be tempting to try to time the market, a more effective strategy is to invest consistently over time. By understanding these principles, investors can make more informed investment decisions and potentially increase their returns.
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