Taxes reduce your investable income
First of all, taxes reduce your investable income, that is, the amount of income you can invest. When you pay taxes before you invest, you have less money to invest in the stock market and other investments.
If you have less money to invest, then you don't earn as high a return. It's that simple.
The good news is, there are ways to reduce the impact of taxes on your investable income. If you are saving for retirement, you can use tax-advantaged accounts. Want to make sure you have the best tax-advantaged accounts for you? Then consider having your investment portfolios reviewed by a licensed advisor like Empower.
Accounts like Traditional IRAs and 401(k)s can help you set aside money for investing before you pay taxes, providing you with more capital to invest now. If you are self-employed or own a business, you can also look into the possibilities of SEP IRAs and Solo 401(k)s. These retirement vehicles allow you to set aside more overall.
Taxes reduce your real returns
Of course, even if you invest tax-deferred, you eventually have to pay taxes. The taxes you pay after you calculate gains reduce your real returns. The earnings you receive from investing are known as capital gains, and the taxes you pay are called capital gains taxes.
Short-term capital gains are taxed at your marginal tax rate, so you end up paying whatever rate your tax bracket is. Long-term capital gains — which apply to investments held for more than a year — often come at a lower rate.
Instead of being taxed at your marginal rate, you are taxed at a preferred rate. You can save a little more if you hold on to your investments for longer.
Unfortunately, the long-term capital gains rules don't apply to tax-advantaged retirement accounts. When you withdraw from your tax-deferred account, you pay at your marginal rate, no matter how long you've held the investment.
One of the ways you can get around this is to use a Roth account. A Roth IRA or a Roth 401(k) allows your earnings to grow tax-free. The downside, though, is that you have to invest with after-tax dollars.
Your investable capital is smaller, but if tax rates go up later, you can be protected since you won't have to pay taxes on your earnings. For the self-employed, a Roth Solo 401(k) can offer the chance to sock away more money in this type of account.
What about tax-efficient investments?
Some investments are more tax-efficient than others. Interest from municipal bonds is not usually taxed at the federal level. There are other investments (like dividend-paying stocks) that sometimes come with preferred tax rates.
However, tax laws can change at any time, rendering tax efficiency useless. Additionally, it doesn't make sense to invest in something just for a perceived tax benefit.
If it doesn't really fit in with your overall investing strategy, it doesn't make sense to invest just because you might get a small tax break. Here's our guide on the best ways to reduce taxes on investments.