For investments that you hold inside tax-sheltered retirement accounts such as IRAs and 401(k) plans, you don’t need to worry about taxes. This money isn’t generally taxed until you actually withdraw funds from the retirement account. Thus you should never invest money that’s inside retirement accounts in other tax-favored investments, such as tax-free money market funds and tax-free bonds. You’re far more likely to make tax-related mistakes investing outside of retirement accounts. Consider the many types of distributions produced by nonretirement account investments that are subject to taxation:
- Interest: Bank accounts, for example, pay you interest that is fully taxable, generally at both the federal and state levels. Bonds (IOUs) issued by corporations also pay interest that is fully taxable. Bonds issued by the federal government, which are known as Treasury bonds, pay interest that is federally taxable.
- Dividends: Many companies distribute some of their profits to shareholders of stock (shares of company ownership) as dividends. Much lower tax rates apply to stock dividends — now 0 percent (that’s right, zero) for those in the federal 10 and 15 percent tax brackets, and only 15 percent for those in all higher tax brackets.
- Capital gains: The profit from the sale of an investment at a price higher than the purchase price is known as a capital gain. Capital gains generally are federally and state taxable. Lower tax rates apply to capital gains for investments held for the long term (see the next section).
This post detail specific tax strategy [ies] to reduce your taxes and maximizing your after-tax returns — that is, the return you actually get to keep after payment of required taxes. Enjoy!
Strategy#1. Buy and Hold For “Long-Term” Capital Gains
A long-term capital gain, which is the profit (sales proceeds minus purchase price) on an investment (such as a stock, bond, or mutual fund) that you own for more than 12 months, is taxed on a different tax-rate schedule. Short-term capital gains (securities held for one year or less) are taxed at your ordinary income tax rate.
The maximum federal tax rate on long-term capital gains is currently just 15 percent for holding periods of more than 12 months. For investors in the two lowest federal income tax brackets — 10 percent and 15 percent — the long-term capital gains tax is now 0 percent for assets held more than 12 months [This is one of last provisions to kick in from the 2003 tax cuts].
When investing outside retirement accounts, investors who frequently trade their investments [or who invest in mutual funds that do the same] should seriously reconsider these strategies and holdings. With longer-term capital gains being taxed at lower tax rates, trading that produces short-term gains (from investments held 12 months or less), which are taxed at ordinary income tax rates, penalizes higher bracket investors the most. The sane strategy of buying and holding not only minimizes your taxes but also reduces trading costs and the likelihood of being whipsawed by fluctuating investment values.
Why, you may wonder; is there a set of capital gains’ tax rates that are different from (lower than) the regular income tax rates ? In addition to the possibility that our government wants to make our tax lives more difficult, some logic lies behind the lower long-term capital gains tax rates. Some argue that this lower tax encourages investment for long-term growth. However, others complain that it’s a tax break that primarily benefits the affluent.
When you buy and hold stocks and stock mutual funds outside retirement accounts, you can now take advantage of two major tax breaks. As we discuss in this post, appreciation on investments held more than 12 months and then sold is taxed at the low capital gains tax rate. Stock dividends (not on real estate investment trusts) are also taxed at these same low tax rates — now 0 percent for those in the federal 10 and 15 percent tax brackets and 15 percent for everyone else.
Strategy#2. Pay Off High-interest Debt
Many folks have credit card or other consumer debt, such as auto loans costing 8 percent, 9 percent, 10 percent, or more per year in interest. Paying off this debt with your savings is like putting your money in an investment with a guaranteed tax-free return that’s equal to the interest rate you were paying on the debt. For example, if you have credit-card debt outstanding at a 15 percent interest rate, paying off that loan is the same as putting your money to work in an investment with a guaranteed 15 percent annual return. Because the interest on consumer debt isn’t tax-deductible, you actually need to earn more than 15 percent on your other investments to net 15 percent after paying taxes.
Still not convinced that paying off consumer debt is a great “investment”? Consider this: Banks and other lenders charge higher rates of interest for consumer debt than for debt on investments [such as real estate and businesses]. Debt for investments is generally available at lower rates of interest and is tax-deductible. Consumer debt is hazardous to your long-term financial health (because you’re borrowing against your future earnings), and it’s more expensive.
In addition to ridding yourself of consumer debt, paying off your mortgage quicker may make sense, too. This financial move isn’t always the best one because the interest rate on mortgage debt is lower than that on consumer debt and is usually tax-deductible.
Strategy#3. Fund Your Retirement Accounts
Take advantage of opportunities to direct your employment earnings into retirement accounts. If you work for a company that offers a retirement savings plan such as a 401(k), try to fund it at the highest level that you can manage. When you earn self-employment income, look into SEP-IRAs and Keoghs.
You get three possible tax bonuses by investing more of your money in retirement accounts:
- Your contributions to the retirement accounts come out of your pay before taxes are figured, which reduces your current tax burden.
- Some employers provide matching contributions, which is free money to you.
- The earnings on the investments inside the retirement accounts compound without taxation until withdrawal. Funding retirement accounts makes particular sense if you can allow the money to compound over many years (at least 10 years, preferably 15 to 20 years or more).
If you need to save money outside retirement accounts for short-term purposes such as buying a car or a home, by all means, don’t do all your saving inside sometimes-difficult and costly-to-access retirement accounts. But if you accumulate money outside retirement accounts with no particular purpose in mind (other than that you like seeing the burgeoning balances), why not get some tax breaks by contributing to retirement accounts? Because your investments can produce taxable distributions, investing money outside retirement accounts requires greater thought and consideration, which is another reason to shelter more of your money in retirement accounts.
Strategy#4. Use Tax-Free Money Market And Bond Funds
A common mistake many people make is not choosing a tax-appropriate investment given their tax bracket. Here are some guidelines for choosing the best type of investment based on your federal tax bracket:
- 33 percent or higher federal tax bracket: If you’re in one of these high brackets, you definitely need to avoid investments that produce taxable income. For tax year 2008, the 33 percent federal bracket started at $164,550 for singles, $182,400 for heads of household, and $200,300 for married couples filing jointly.
- 25 or 28 percent federal tax bracket: If you invest outside retirement accounts, in most cases, you should be as well or slightly better off in investments that don’t produce taxable income. This may not be the case, however, if you’re in tax-free money market and bond funds whose yields are depressed because of a combination of low interest rates and too high operating expenses.
- 10 or 15 percent federal tax bracket: Investments that produce taxable income are generally just fine. You’ll likely end up with less if you purchase investments that produce tax-free income, because these investments yield less than comparable taxable ones even after factoring in the taxes you pay on those taxable investments.
When you’re investing your money, it isn’t the return that your investment earns that matters; what matters is the return you actually get to keep after paying taxes. The following paragraph describe some of the best investment choices you can make to reduce your overall tax burden and maximize your after-tax return.
Determining Whether Tax-free Funds Will Pay More
If you’re in the federal 33 percent tax bracket or higher, you will usually come out ahead in tax-free investments. Making the comparison properly means factoring in federal and state taxes. For example, suppose that you call a fund company and the representative tells you that the company’s taxable money market fund currently yields 3 percent. The yield or dividend on this fund is fully taxable.
Further suppose that you’re a resident of California —home to beautiful beaches and rumbling earthquakes —and that the same fund company’s California money market fund currently yields 2 percent. The California tax-free money market fund pays dividends that are free from federal and California state tax. Thus you get to keep all 2 percent that you earn. The income you earn on the taxable fund, on the other hand, is taxed.
So here’s how you compare the two:
Yield on tax-free fund/yield on taxable fund
[0.02 (2.0%)] / [0.03 (3.0%)] = 0.67
In other words, the tax-free funds pay a yield of 67 percent of the yield of the taxable fund. Thus, if you must pay more than 33 percent (1.0 – 0.67) in federal and California state tax, you net more in the tax-free fund. If you do this analysis comparing some funds today, be aware that yields do change. The difference in yields between tax-free and taxable funds widens and narrows a bit over time.
Strategy#5. Invest In Tax-Friendly Stock Funds
When selecting investments, people often mistakenly focus on past rates of return. We all know that the past is no guarantee for the future. But an even worse mistake is choosing an investment with a reportedly high rate of return without considering tax consequences. Numerous mutual funds effectively reduce their shareholders’ returns because of their tendency to produce more taxable distributions (dividends and capital gains).
Historically, however, many mutual fund investors and publications haven’t compared the tax-friendliness of similar mutual funds. Just as you need to avoid investing in funds with high sales commissions, high annual operating expenses, and poor relative performance, you also should avoid tax-unfriendly funds when investing outside of retirement accounts.
When comparing two similar funds, most people prefer a fund that averages returns of 14 percent per year instead of a fund earning 12 percent. But what if the 14 percent-per-year fund causes you to pay a lot more in taxes? What if, after factoring in taxes, the 14-percent per year fund nets just 9 percent, while the 12-percent-per-year fund nets an effective 10 percent return? In that case, you’d be unwise to choose a fund solely on the basis of the higher reported rate of return.
Fund distributions = more taxes!
All stock mutual fund managers buy and sell stocks during the course of a year. Whenever a mutual fund manager sells securities, any gain from those securities must be distributed, by year’s end, to the fund shareholders. Securities sold at a loss can offset those liquidated at a profit. When a fund manager has a tendency to cash in more winners than losers, significant capital gains distributions can result.
Choosing mutual funds that minimize capital gains distributions, especially short-term capital gains distributions that are taxed at the higher ordinary income tax rates rather than the favored long-term capital gains rates we discuss earlier in this chapter, can help investors defer and minimize taxes on their profits. By allowing their capital to continue compounding, as it would in an IRA or other retirement account, fund shareholders receive a higher total return. (You can find the historic capital gains distribution information on a fund by examining its prospectus).
Long-term investors benefit the most from choosing mutual funds that minimize capital gains distributions. The more years that appreciation can compound in a mutual fund without being taxed, the greater the value to the fund investor. When you invest in stock funds inside retirement accounts, you need not worry about capital gains distributions.
In addition to capital gains distributions, mutual funds produce dividends that are subject to normal income tax rates (except in the case of qualified stock dividends, which are taxed at the same low rates applied to long-term capital gains). Again, all things being equal, nonretirement account investors in high tax brackets should avoid funds that tend to pay a lot of dividends (from bonds and money market funds). Hold such funds inside of tax-sheltered retirement accounts.
Timing of Fund Purchases Affects Tax Bill
Investors who purchase mutual funds outside tax-sheltered retirement accounts also need to consider the time of year they purchase shares in funds, so they can minimize the tax bite. Specifically, investors should try to purchase funds after rather than just before the fund makes the following types of distributions:
- Capital gains distributions. December is the most common month in which mutual funds make capital gains distributions. If making purchases late in the year, investors should find out whether and when the fund may make a significant capital gains distribution. Often, the unaware investor buys a mutual fund just prior to a distribution, only to see the value of the fund decline. But the investor must still pay income tax on the distribution. The December payout is generally larger when a fund has had a particularly good performance year and when the fund manager has done a lot of trading that year.
- Dividend distributions. Some stock funds that pay reasonably high dividends (perhaps because they also hold bonds) tend to pay out dividends quarterly — typically on a March, June, September, and December cycle. Try to avoid buying shares of these funds just before they pay. Make purchases early in each calendar quarter (early in the months of January, April, July, and October). Remember that the share price of the fund is reduced by the amount of the dividend, and the dividend is taxable.
Don’t get too concerned about when funds make distributions, because you can miss out on bigger profits by being so focused on avoiding a little bit of tax. If you want to be sure of the dates when a particular fund makes distributions, call the specific fund you have in mind.
Understanding the Tax Virtues Of Index Funds
Mutual fund managers of actively managed portfolios, in their attempts to increase their shareholders’ returns, buy and sell individual securities more frequently. However, this trading increases the chances of a fund needing to make significant capital gains distributions.
Index funds, by contrast, are mutual funds that invest in a relatively fixed portfolio of securities. They don’t attempt to beat the market averages or indexes. Rather, they invest in the securities to mirror or match the performance of an underlying index.
Although index funds can’t beat the market, they have the following advantages over actively managed funds:
- Because index funds trade much less often than actively managed funds, index fund investors benefit from lower brokerage fees.
- Because significant ongoing research need not be conducted to identify companies in which to invest, index funds can be run with far lower operating expenses. All factors being equal, lower brokerage and operating costs translate into higher shareholder returns. Because index funds trade less often, they tend to produce lower capital gains distributions.
- For mutual funds held outside of tax-sheltered retirement accounts, this reduced trading effectively increases an investor’s total rate of return. Thus index mutual funds are tax-friendlier.
Should You Change Investment Strategies With New Tax Laws?
In 2003, tax law changes reduced the tax rate on most stock dividends and capital gains. Because of those changes, assets that had appreciation potential (like stocks) and that pay corporate dividends (stocks again) were given a boost.
Anything which increases the after-tax return of stocks is good for the stock market [The Vanguard Group].
Now, there’s talk of hiking the tax rates on stock dividends and capital gains. The current low rates expire in 2010. Before we jump ahead, however, we focus on the current low rates, which should persist for most Americans earning low to moderate incomes.
Remember that your goals and willingness to take on risk should still drive your overall asset allocation. So, don’t skew your asset allocation to dividend-paying stocks instead of income-producing bonds. The fundamental characteristics of stocks compared with bonds haven’t been altered by these lower tax rates. In the short term, bonds tend to be less volatile than stocks, but in the long run, stocks generally produce higher returns.
You won’t benefit from low long-term capital gains tax rates and stock dividends tax rates (now just 15 percent and 0 percent for those in the 10 and 15 percent federal income tax brackets) for investments held inside retirement accounts. When investment earnings are withdrawn from all retirement accounts except Roth IRAs, those returns are taxed as ordinary income. (With a Roth IRA, qualified withdrawals are free of taxation.)
Despite the fact that some of the many tax benefits of retirement accounts were negated by lower tax rates, investors should still generally take advantage of funding retirement plans that provide for immediate tax reductions.
When taking into account the advantage of investing on a pre-tax basis in the tax-deferred account versus an after-tax basis in the taxable account, the tax-deferred account proves more advantageous, though its relative advantage compared with the taxable account is not as great as it would be under current law [T. Rowe Price].
If you’re in a high enough tax bracket (federal 33 percent or higher), you may come out ahead with tax-free investments. Tax-free investments yield less than comparable investments that produce taxable earnings. But the earnings from tax-free investments can end up being greater than what you’re left with from taxable investments after paying required federal and state taxes.
Tax-free money market funds, offered by mutual fund companies, can be a better alternative to bank savings accounts that pay interest (which is subject to taxation). The best money market funds pay higher yields and give you check-writing privileges. If you’re in a high tax bracket, you can select a tax-free money market fund, which pays dividends that are free from federal and sometimes from state tax. You can’t get this feature with bank savings accounts.
Unlike bank savings accounts, the FDIC (Federal Deposit Insurance Corporation) doesn’t insure money market mutual funds. For all intents and purposes, though, money market funds and bank accounts have equivalent safety. Don’t allow the lack of FDIC insurance to concern you, because fund companies haven’t failed. And in those rare instances when a money fund’s investments have lost value, the parent company has infused capital to ensure no loss of principal on the investor’s part.
Just as you can invest in a tax-free money market fund, so too can you invest in tax-free bonds via a tax-free bond mutual fund. These funds are suitable for higher-tax-bracket investors who want an investment that pays a better return than a money market fund without the risk of the stock market. Bond funds are intended as longer-term investments (although they offer daily liquidity, they do fluctuate in value).
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