Investment planning can be important for several reasons. However, any discussion of investment planning is incomplete without a thorough understanding of the applicable income tax ramifications. Tax planning can help you reduce the tax cost of your investments. Once you've created an investment plan to work toward your various financial goals, you should take advantage of the tax rules to ensure that you maximize the after-tax return on your investments. In other words, your goal is to select tax-favorable investments that are consistent with your overall investment plan.

In order to engage in investment tax planning, you need to understand how investments are taxed (including the concepts of capital gain income and ordinary income) and how to compare different investment vehicles. You also need to know how your own tax situation (i.e., your tax bracket, holding period, and tax basis) affects the taxation of your capital assets.

Caution: Investment choices should not be based on tax considerations alone, but should be based on several factors including your time horizons and risk tolerance.

How does investment tax planning work?
Similar investments may carry substantially different tax costs. It is important to identify the differences and evaluate the costs. Consider the following points:

Investment earnings are taxed in different ways
A myriad of investment vehicles are available to you. For instance, you can invest in stocks, bonds, mutual funds, money market funds, real estate, commodities, or your own business. Investment earnings are taxed in many different ways. Consequently, some investments earn less after tax than others. By taking advantage of these differences, you may save money. In addition, your tax savings can preserve your investments and, as a result, enhance future investment growth.

Investment tax planning can maximize your wealth
Tax investment planning involves maximizing the after-tax return on your investments. This is beneficial because the wealth that remains after you pay your taxes is ultimately more important to you than the value of your investments. Thus, one goal of investment tax planning is to maximize future wealth. To do so, you need to know a little bit about taxes. In particular, you need to know the following:

  • How your investments are taxed
  • The before- and after-tax rates of return on your investments
  • How to compare investments in light of after-tax return

Your tax treatment
Your investment tax situation depends on several factors. In particular, you'll need to know the adjusted tax basis of your capital assets, the sale price of the assets, the holding period, the amount of the capital gain or loss, the amount of your ordinary investment income or losses, and your marginal tax bracket.