Taxation is something we all have to deal with, and it applies to all the money we make, including profits from investments. The goal is to look to avoid paying more tax than we need to. This requires both an understanding of how different types of investment income are taxed, to help us choose them, as well as how cashing in investments at various times in our lives will affect the amount of tax we will pay.

It’s All About Net Income

With few exceptions, any money that we make is subject to taxation. The more we make, the more tax we tend to pay, and making more money will sometimes involve paying a higher percentage of our income to governments in tax.

While there are certain strategies that we may use to look to minimize the amount of tax we are subject to paying, we must never lose sight of the fact that the goal isn’t necessarily to pay the least tax, it’s to show the highest amount of income net of tax.

While this may seem to be quite obvious, it is possible and not that uncommon for people to become preoccupied with taxes to the extent that they are allowing this to impede the growth of their portfolios.

TaxationThere are many examples of this, and a simple one would be deciding between one investment which averaged a 10% return and one that only averaged 5% but was given preferential tax treatment.

In this case, all things being equal, the extra income earned with the investment that yielded the 10% would come out ahead in all scenarios other than if the difference in the tax rates were 50% or more.

That would be the breakeven point here, as a 50% tax rate on the 10% investment would net a 5% return, the same as the 5% return would provide if it were tax free. In reality though, we would seldom see such a disparity in tax rates between investments and therefore one would be better off paying more tax in this case and seeing their net proceeds increase.

We therefore need to always be aware of what we could call the big picture, the net effect of decisions surrounding taxation, which always will cash out to how much money we get to keep with one scenario versus another.

Since investments are usually not straightforward, these calculations aren’t usually as simple as in our example. Many investments have variable returns, so we have to look to come up with as good of a projection as we can as to what we may expect on the balance of probabilities, involving looking at past performance and averaging this out, as well as accounting for any other factors that may come into play.

It Pays to be Aware of Tax Consequences

When people look at investment strategies, they don’t always take tax consequences into account properly. Taxation issues may come into play though, and although this need not be the case, if for instance governments gave all income similar tax treatment, the fact is that they usually don’t and will construct various rules around this that we need to be aware of.

While it may be the case that governments would benefit from simpler tax codes, simplicity isn’t usually a goal here, and legislators do not fear over complexity in the least it seems, and seem to go out of their way to make things more complicated than they perhaps need to be.

In terms of one’s personal income, this can be complicated enough, depending on where you live, and this is certainly the case for those living in the United States. U.S. tax codes are infamously complex, and although other countries may have simpler tax codes, they usually are not so simple or as simple as people would like.

When things go from the simple to the more complex, this will often necessitate the need for professional tax advice. Nothing in the articles on our site seeks to substitute for that, as the goal here is to only provide an overview of some of the matters that pertain to investment and taxation.

Given that people’s circumstances may differ greatly, and not the least of these differences is where you live, the fees that we have to pay in order to get professional tax advice can be well worth the money, especially given the penalties that one may be subject to if one gets this wrong.

This all starts with an awareness of what the issues may be though, whether or not a certain type of investment may have different tax treatment over another, and this is something that all investors should at least be aware of.

Marginal Tax Rates and Investing

Since taxation tends to be progressive, different levels of income will be taxed at different rates. This is organized by bracketing given amounts of income according to a given tax rate. For instance, just to use some simple numbers, the first $10,000 you earn may not be subject to any tax at all.

The next $10,000 may be assessed a certain tax rate, the next $20,000 will be assessed at a higher rate, and so on, up to the largest tax bracket offered by the taxation system one is subject to.

Not everyone is aware of how this works though and some think that all their income is taxed at a certain rate if they move up a tax bracket, and may even worry about having their entire income assessed at this new tax rate should their bracket increase.

Given a certain level of income, there will be a certain amount of money that one can earn which will be assessed at the tax rate of their current bracket, and beyond that the excess will be subject to the higher rate of the bracket or brackets above it.

The current rate of taxation on the next dollar earned is what we call one’s marginal tax rate. This is the rate we tend to use when we look at what tax we will be subject to with investment earnings, unless the earnings receive preferential tax treatment.

However, that’s not quite the case, as it is only the amount until we hit the next tax bracket that we’ll pay this marginal tax rate on. So, it pays to be aware of how much room we have in our current tax bracket to make an informed decision here, and what the rate may be if we exceed that and part of our earnings become taxed at a higher rate.

Tax Rates Only Matter When Income is Realized

Some types of investments are taxed immediately with no preferential treatment, for instance interest earned in a given year. Depending on what one’s income level is during that year, this may be the worst time to have to pay tax on this, if one’s rate is higher, although that’s not always the case.

If one’s income is lower for the current year though, that may cause one’s tax rate on the income to be lower than normal, or if one’s income is higher, one may end up paying more tax than normal on the interest income earned.

One’s current level of income at a given point of time, and in particular, one’s marginal tax rate at that time, is going to matter a lot in our calculations and projections, as the goal here is to look to minimize the amount of tax we pay.

Once again though, this isn’t the only consideration, and as mentioned, we want to always be looking at the big picture, which includes but is not limited to tax considerations.

Perhaps we really need the money for something, and while it may not be the ideal time to cash in an investment, for instance to sell some stocks or to cash in part of our tax deferred savings, the present need for the money may outweigh tax considerations.

So looking to manage the tax we pay is subject to the consideration of all other things being equal, and as important as tax management is, there are other things that need to be accounted for as well.

One of the biggest considerations in assessing the potential tax liability of our investments is looking to project what our marginal tax rate will be at the time of declaring the income. This usually means when we retire, although this applies equally to any time we are looking to cash in investments.

Overall Strategies for Managing Taxation

As complex as assessing what the best strategy may be as far as looking to minimize tax owed on investment income, there are some simple rules of thumb that apply generally which we need to be aware of.

As a general rule, the lower your income, the better it is to cash in investments, for instance when your income is reduced in retirement. It is therefore preferable to defer taxation to those times where you will pay less in tax than you would at the present time.

This not only offers investors the benefit of tax savings down the road, the tax money that becomes deferred can be invested as well. Although the investment income that is earned from the tax deferred will usually be subject to taxation when cashed in, this still provides a profit for the investor, the total amount earned less the tax rate it becomes subject to.

The second major thing to be aware of is when one’s investment income is subject to taxation. Many people are not aware that mutual funds buy and sell securities on their behalf on a fairly regular basis, and when these investments become sold, they become subject to taxation, which gets passed on to investors.

Therefore, mutual funds do not have the same tax deferral properties that owning the investment products yourself would have, for instance by buying and holding stock. On the other hand, holding the stock beyond a certain point may not be advisable, and therefore one’s overall returns may be enhanced by liquidating certain positions, even though this may involve a tax liability for the investor.

This does serve to illustrate that taxation is not the only concern with investments. As well, most investors lack the skill and confidence to manage their own investments, so looking to avoid tax liabilities from mutual fund disbursements may be a no- issue if there isn’t another good alternative for them.

We also need to have a general idea of the differences between types of investments where taxation is concerned, for instance, knowing what preferential treatment things like capital gains and dividends may represent.

As a general rule, capital gains get the best tax treatment, followed by qualified dividend income, with interest income usually assessed at the full rate of tax. Knowing this, we can take this information and incorporate it into our overall strategies, to seek to earn the highest amount of net return when the dust all settles.

That’s the real goal here, to have the maximum amount of money in our hands, regardless of how much the government gets to keep.

Taxation FAQs

  • What is purpose of taxation?
    Since governments spend money, they need a source of revenue. They could borrow, but to borrow you need income flows to repay debt, and tax revenue serves as this income flow for governments. Governments can then fund their activities by both collecting tax revenue and borrowing.
  • What are the types of taxes?
    There are many different types of taxes. We pay income tax and payroll tax on our earnings and sales tax when we purchase many things. We pay property tax on our home or indirectly if we rent. We pay capital gains taxes when we invest successfully, and estate taxes are assessed upon us when we die. There are also various corporate taxes.
  • What is the difference between tax and taxation?
    A tax is a certain amount that one is required to pay to provide what the government has determined is their share in a transaction. For example, when you get paid, they may take a third of your salary as tax. Taxation describes the effect of taxes being paid, where you pay taxes and that results in taxation.
  • What are the basic principles of taxation?
    The basic principles of taxation start with money collected being used for public purposes. Taxes can only be enacted by proper authority and they are limited to the jurisdiction of the authorizing body. Either persons or property may be taxed. The scope of a tax and its rates must be both known and applied uniformly.
  • Which tax is an indirect tax?
    An indirect tax is a tax that is not directly applied to a transaction but is included in it as a result of it being paid up the line. When you buy something, you pay the sales tax on it, but there may also be other taxes that are included in the pre-tax price you pay. This also includes tariffs, which are a form of indirect tax and gets added to prices when goods are imported.
  • What type of tax is a property tax?
    Property taxes constitute their own category of taxation, where owners of properties are taxed a certain percentage of the value of the property per year. The reasoning behind property tax is that governments will contribute to the welfare of landowners and are entitled to collect taxes for this.
  • What is indirect tax with example?
    An indirect tax is a tax that has been paid on something but isn’t made transparent in the selling price. When you pay sales tax, the rate gets applied to the purchase price and the tax is therefore transparent. A duty imposed upon the price would already be included in the sale price. The importer paid the duty directly, and the purchaser paid it indirectly.
  • Do savings accounts get taxed?
    Income earned with a savings account is considered ordinary income, similar to what you earn at a job. You will pay taxes on any amount of interest earned over $10, although the IRS does require you to report all income, however small. Any bonuses that were provided to open a savings account must also be included in the amount reported as earnings.
  • How can I reduce my taxable income?
    Aside from reducing your income itself, which is actually done in some cases by deferring it, reducing your taxable income comes down to being able to deduct more of your total income from your taxable income. In addition to making the standard deductions, you also want to make sure you are taking advantage of whatever others you are entitled to.
  • What investments reduce taxable income?
    There are two types of income that are taxed more favorably than ordinary income, which are capital gains and qualified dividend income. Any investment that accumulates value provides capital gains, like stocks, and stocks also pay out dividends which can provide further tax benefits.
  • How can I pay less income tax?
    Paying less income tax requires that we either reduce our income, make more tax deductions, or both. If we have an opportunity to defer income to a time where we will pay less tax, like a retirement account allows us, we can pay less tax in the end. We also can ensure that we are making all allowable deductions.
  • How can I maximize my tax refund?
    Maximizing your tax refund always involves your ensuring that you are deducting the maximum amount from your total income in order to minimize your taxable income. You may also be able to decrease your income by contributing to an IRA after tax, where your contribution can be used as a deduction and the tax owing on it deferred.

References & Scholarly Articles for Taxation

Books on Taxation

  • Tax-Free Wealth: How to Build Massive Wealth by Permanently Lowering Your Taxes (Author: Tom Wheelwright, Originally published: March 2012)
  • The Tax and Legal Playbook: Game-Changing Solutions To Your Small Business Questions (Author: Mark J. Kohler, Originally published: 2015)
  • Taxation of Individual Income (Author: J. Martin Burke and Michael Friel, Originally published: 1988)
  • Taxes Made Simple: Income Taxes Explained in 100 Pages Or Less (Author: Mike Piper, Originally published: 2008)


Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.

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