Monday, August 27, 2012

The Folly of Chasing Returns (part 2)

The Folly of Chasing Returns (part 2)
From my last column, we know that three important questions must be asked in comparing returns among various investments. First, we discounted the returns by the costs/fees associated with them.
Question #2 would be:
Is this return/interest before or after any applicable income taxes?

I like to call this the tax efficiency of the return. If you think about it, it is possible for the investment that generates the most money (the largest literal balance) to end up having the lower spendable dollar-for-dollar income after applicable taxes, isn’t it?
By way of a quick example, if the after-cost returns for Investments A and B were 7 and 5.5 percent, respectively, many folks might be tempted to quickly go with A. However, that could end up being a mistake if the investor neglected to look into their tax efficiencies.
Let’s say the investor in question happens to be in a 30 percent marginal tax bracket, and Investment A’s income were taxable, while Investment B’s was income tax free. That would shave off 2.1 percent (7 percent multiplied by the 30 percent tax rate) from Investment A’s return, leaving a net spendable income of 4.9 percent. Obviously with this new information, Investment B’s 5.5 percent would be the superior choice. But you’ve to realize how we got here.
This may seem like a pretty straight-forward, obvious step to take, but I can’t begin to tell you how many retirement investors have been (and are today still being) led to compare return options without considering the applicable taxes. At the end of the day, irrespective of what your financial advisor thinks or believes, the fact of the matter is that what should matter most to you is  how much of your earnings you’d actually get to spend – after taxes.
We’ll discuss the third question in the next column.
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