At the risk of stating the obvious, it's not how much you earn from your investments that counts, it's how much you keep—and that can be eroded significantly by the "tax drag" on certain investments. That's why it makes sense to include tax-favored investments in your portfolio.
The accompanying chart shows seven different kinds of assets categorized according to the tax consequences of each one. For the most part, they're in order from the least tax-desirable assets on the left to the more favorable ones on the right.
1. Interest income: This includes interest you earn on money market funds, corporate bonds, and U.S. Treasury bonds. This income is fully taxable at ordinary income rates topping out at 39.6%.
2. Dividend income: Ordinary dividends from stocks are taxable as ordinary income. But most dividends that you get are "qualified," according to tax rules, and are taxed at preferential rates of 15% for most investors and 20% for those in the top income bracket. Meanwhile, those in the two lowest income brackets may enjoy a 0% rate on qualified dividends.
3. Capital gain income: Long-term capital gains on the sale of securities you've held for more than a year are taxed at the same preferential rates as qualified dividends, and you can reduce your tax bill further by offsetting such gains with capital losses. There's also a "step-up in basis" on inherited assets; for capital gains purposes, their tax basis is adjusted to their value at the time of the death of the person making the bequest.
4. Tax-exempt interest: This category includes income from municipal bonds and municipal bond funds. It's exempt from federal income tax (and possibly state income tax), but interest from "private activity" munis may be taxable if you have to pay the alternative minimum tax (AMT). Also, tax-exempt income may increase a retiree's tax on Social Security benefits.
5. Pension and IRA income: Income earned in employer-sponsored retirement plans—including pension, profit-sharing, and 401(k) plans—is tax-deferred until you make withdrawals during retirement, when distributions are taxed as ordinary income. The same is true for traditional IRAs. But there's no step-up in basis if these assets are passed along to heirs and required minimum distributions (RMDs) begin after age 70½.
6. Real estate: This asset deserves special recognition. Capital gain is deferred until the property is sold, and may be postponed even longer under a Section 1031 exchange. In the meantime, depreciation deductions can help shield current income from tax. Rules for long-term capital gains also apply.
7. Roth IRA and insurance: Unlike withdrawals from traditional IRAs, most distributions from Roth IRAs are completely tax-free after five years and there are no RMDs. A cash value life insurance policy can provide both tax-deferred growth and tax-free payouts to your heirs.
Don't overlook the tax ramifications of investments. Find the proper mix of asset classes for your situation.