How to Decide whether to Invest for Growth vs Income

A common question arises when we are investing. Do we invest for growth or do we go for income? I am going to distinguish the tax effects of doing both. From a purely taxation perspective, investing for growth seems to make more sense. I’ll explain why.

Below is the marginal tax rates for U.S. citizens for 2007.

Tax Year: 2007
Filing Status: Head of Household

If your taxable income is between… Your tax bracket is:
0 and 11,200 10%
11,200 and 42,650 15%
42,650 and 110,100 25%
110,100 and 178,350 28%
178,350 and 349,700 33%
349,700 and Above 35%

To make an example, suppose your taxable income (after deductions and exemptions) was exactly $48,201 in 2007 (avg household income per US Census) and your status was Head of Household; then your tax would be calculated like this:

11,200-0 11,200 x 0.1 = $1,120
42,650-11,200 31,450 x 0.15 = $4,718
48,201-42,650 5,551 x 0.25 = $1,388 <— Their marginal rate is 25%
Total: $23,723

Income?

Take the above household and assume they have $10,000 saved to invest. If they put it in an interest bearing account of some sort where they get a 9% return, they will get $900 interest at the end of each year. After taxes (marginal rate is 25%), the household will get $675 of interest. Their interest would be taxed as ordinary income and their marginal rate would apply.

We will assume the household continues to reinvest the income each year for 5yrs. At the end of 5yrs after taxes, the household will have $13,862 after all taxes.

or Growth?

Now let’s take the same example, but now let’s invest in a financial instrument that will give us long-term capital gain instead of income each year. Our return in this case will be the same at 9%. Our gain will end up being taxed at 15% long-term capital gains, but only when we sell. So we will be taxed once at the end of 5 yrs when we sell.

Our money will grow faster because we will be getting the full 9% compounded. In fact our $10,000 will grow to $14,578 after paying the 15% capital gains tax at the end of year 5.

We end up with $716 more with the investing for growth model or 5.16% more.

Which to Choose?

There are other decision factors when choosing whether to invest for income or growth. You must take your own situation into account.

Why Income?

• You are approaching a period in life where you will be relying on this income for lifestyle maintenance. In this case you wouldn’t be reinvesting your income, but using it.
• You are expecting some potential large expense. For example your car may be on its last leg. It may die tomorrow or maybe even 3 yrs from now. You would like to have the availability of your funds “just in case”
• You feel more secure. Some people down right like the feeling of getting periodic positive feedback from their investments.

Why Growth?

• You want to accumulate wealth by minimizing taxes.
• You don’t need the money for current needs and can wait to reap the benefits.