4.2. Taxing Decisions

Every tax season, the federal and state governments wait impatiently for their tax fix from the money you make, whether it comes from your salary, poker winnings, or earnings from your investments. Paying taxes on investment gains and income hurts, because you're handing over money that would otherwise be compounding like crazy to help you reach your financial goals (Section 1.2).

Because retirement, college education, and health care are so important, you can get some tax relief by putting money for those goals into several types of government-sponsored tax-advantaged accounts (a fancy name for accounts that give you some kind of tax break). Even if you invest in taxable investments, you can minimize your tax bill by allocating those investments carefully between taxable and tax-advantaged accounts. In other words, put your most taxable investments in tax-advantaged accounts, and put investments with the smallest tax bills in your taxable accounts.

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Note:

The following chapters give you the full scoop on tax-advantaged accounts for long-term goals:

• Chapter 10 covers retirement investment accounts.

• Chapter 11 discusses options for saving for college.

• Chapter 12 talks about how to save for health care.

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You'll see why paying attention to taxes is important below. Then you'll get an introduction to the different types of tax-advantaged accounts available. And finally, you'll learn the pros and cons of putting specific types of investments in tax-advantaged and taxable accounts.

4.2.1. The Big Tax Bite

In Chapter 1, you learned why you need the higher returns that investing provides to beat inflation and reach your financial goals. But just when you thought you had the inflation problem licked, you realize that taxes nibble away at your nest egg like money-eating piranhas.

Bonds and REITs deliver lower long-term returns than stocks do (Section 9.2), and then, to make matters worse, returns from them get taxed as ordinary income—at the highest tax rate you pay, in other words. Long-term capital gains (like those you get when you sell a stock after holding it for more than a year) and stock dividends deliver higher long-term returns and have the additional advantage of a lower tax rate.

The table below summarizes tax rates for different types of investment returns for someone in the 25% tax bracket (with a taxable income of between $33,950 and $82,250).

Investment return	Tax rate
Bond interest	Ordinary income: 25%
REIT dividends	Ordinary income: 25%
Stock dividends	15% (5% for people in the 10% or 15% tax bracket)
Short-term capital gains (held less than 1 year)	Ordinary income: 25%
Long-term capital gains (held longer than 1 year)	15% (0% for people in the 10% or 15% tax bracket)

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Note:

Mutual funds distribute interest, dividends, and capital gains that their underlying investments produce during a year. If you hold mutual funds in a taxable account, you have to pay taxes on those distributions as if you owned the individual securities. Mutual funds that don't buy and sell frequently, such as index funds, don't generate as much in capital gains, which reduces the capital gains taxes you owe (Section 4.2.1).

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Although 2010 tax rates are as low as rates have been in years, even relatively benign tax rates dramatically reduce your investment results. Here's an example:

• Say you're single and make $50,000 a year, which puts you in the 25% tax bracket.

• You invest $50,000 in one lump sum, allocated to 60% stocks, 20% bonds, and 20% REITs.

• Assume that stock dividends and capital gains provide a total return of 10%; your bonds pay 5%; and your REITs return 6%.

• Other than rebalancing your portfolio to maintain the percentages in each type of investment, you let your portfolio grow for 40 years.

The table below shows that taxes reduce your overall return from 8.2% to 6.75% per year. That doesn't sound like much, but over 40 years, that smaller return cuts your retirement portfolio by about 40%, from $1,169,662 to $681,845.

4.2.2. Making the Most of Tax-Advantaged Accounts

Tax-advantaged accounts come with a variety of features, but the most common characteristic is delaying the time when you have to pay taxes. Tax-deferred means your money can grow unfettered by taxes, which come due only when you withdraw from the account. You can reinvest the full amount of interest, dividends, and capital gains you earn to compound for years without a dollar going to taxes. Only when you withdraw money during retirement do you pay taxes; at that time, your tax rate might be lower.

Chapters Chapter 10, Chapter 11, and Chapter 12 give you the full rundown on different types of tax-advantaged accounts, but here's a quick introduction:

• 401(k) and 403(b). These tax-deferred accounts (Section 10.2.1) have become the mainstay for employer-sponsored retirement savings, with the majority of employers choosing to offer them over traditional pension plans. You contribute a percentage of your paycheck before paying taxes on it, so your tax savings reduce how much you pay out of pocket for your contribution. For example, if you're in the 25% tax bracket and contribute $10,000 to your 401(k) or 403(b), you save $2,500 in taxes, so your net out of pocket is only $7,500.

  In 2010, the maximum annual contribution is $16,500. (If you're over 50, you can add a catch-up contribution of up to $5,500.) You must start withdrawing from your account when you're 70 ½.

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  Tip:

  If your company matches a portion of what you contribute, that match is like an immediate 100% return on the portion the company matches. It's unlikely you'll find a return that good elsewhere, so if you can't afford to contribute the maximum amount to your 401(k), at the least, contribute enough to get the full company match.

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• Traditional IRA. Anyone with earned income (salary, wages, tips, bonuses, and so on) can contribute to a traditional IRA, another tax-deferred account option. If you've contributed the maximum to your 401(k) or 403(b), a traditional IRA is one way to get more money into retirement savings. In 2010, you can contribute up to $5,000 (plus an additional $1,000 catch-up contribution if you're over 50). Your contributions might be tax-deductible depending on your income. For example, if you're single and your adjusted gross income is less than $56,000, your entire contribution is tax deductible.

  You must be younger than 70 ½ and have earned income to contribute to a traditional IRA. As with 401(k) plans, you must start withdrawing when you reach age 70 ½.

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  Note:

  If you switch jobs and don't want to keep your retirement funds in your employer-sponsored retirement plan, you can move your money into a rollover IRA to continue the tax deferral.

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• Roth IRA. Similar to traditional IRAs, 401(k)s, and 403(b)s, you don't pay taxes on interest, dividends, and capital gains in a Roth IRA (Section 10.2.2.2). What gets everyone's attention is that you withdraw from these accounts tax-free after the age of 59 ½. The catch is that contributions to a Roth IRA aren't tax deductible. That is, you pay taxes on the money before you contribute to the account. With some income limitations, Roths have the same contribution and catch-up limits as traditional IRAs.

  Roth IRAs have other features that make them attractive for saving for your later retirement years. You can continue to contribute after you reach 70 ½, and there's no mandatory annual distribution at any time. Because you contribute after-tax money, you can withdraw your contributions at any time without paying taxes or penalties.

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  Note:

  Because you contribute after-tax, you can withdraw your contributions without paying taxes or penalties. Before you can withdraw earnings tax-free, you must be 59 ½ and have converted or contributed to the Roth at least 5 years earlier.

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• Roth conversion. If you convert a traditional or rollover IRA to a Roth IRA, you have to pay taxes on the tax-deferred contributions you made to the original account. Section 10.2.3 helps you decide whether a conversion makes sense for you.

• Inherited IRA. A beneficiary of an IRA can transfer the money into an inherited IRA to keep the tax-deferral going until the IRS requires distribution. The tax rules for inherited IRAs make Einstein's theory of relativity look like a piece of cake, so consulting a tax advisor is a good idea if you inherit an IRA.

• SEP-IRA. For small businesses or self-employed individuals, the simplified employee pension IRA (SEP-IRA) is the easiest pension plan option. You can contribute up to 25% of your income each year (to a maximum $49,000 in 2010). You can set up a SEP-IRA for a side business even if you already have a 401(k) at your day job.

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  Note:

  See Retirement Plans for Small Businesses to learn about other retirement account options for small businesses, such as Keogh and SIMPLE plans.

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• Section 529 college savings plan. Investments grow tax-deferred in these popular college savings plans. Withdrawals are tax-free as long as you use them for qualified educational expenses (Section 11.2.1). The contribution limits are high, sometimes as much as $300,000. Whoever contributes to the account is the owner, who can then name a family member as the beneficiary. That's good news for two reasons. First, colleges don't take the 529 investment into account when they calculate a student's financial aid, because the account isn't in the student's name. Second, if the current 529 beneficiary ends up getting a big scholarship, you can change the beneficiary.

• Section 529 college prepaid plan. Prepaid plans lock in future tuition costs at today's rates (Section 11.2.2). They aren't as popular as 529 savings plans, because they make it harder to roll over into another plan or switch to another beneficiary.

• Coverdell education savings account. Investments in these accounts grow tax-deferred, and withdrawals are tax-free if you use them for qualified educational expenses. The big drawback to these accounts is the $2,000 annual contribution limit, a drop in the bucket for college costs.

• Health savings account. If you have a high-deductible health insurance plan, you can set up a health savings account (HSA), described in detail on Section 12.4. In 2010, an individual can contribute up to $3,050 pre-tax with a $1,000 catch-up if you're 55 or older. Unlike with flexible spending accounts, you don't have to use the money you contribute during a specific year. You can invest the money in the same kinds of options you have with an IRA. Withdrawals for health care are tax-free.

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Note:

Medical savings accounts (MSA) work like health savings accounts, except that only self-employed people or employers with 50 or fewer employees qualify for them.

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4.2.3. Tax-Advantaged or Taxable: Where to Put Investments

Tax-advantaged accounts limit how much you can contribute each year. If you're saving for a goal that has tax-advantaged account options (retirement, college, and health care), rule number one is to contribute as much as you can to these accounts before you contribute to taxable accounts.

After that, you have some decisions to make about which investments to keep in tax-advantaged and taxable accounts. In short, keep investments with the highest tax bills in your tax-advantaged accounts and those with lower tax bills in taxable accounts.

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Note:

The ultimate investment savings comes, sadly, when you die. Your beneficiaries inherit the stock you owned on a stepped-up basis, which means that they inherit it as though they paid market value for the investment on the date of your death. That means your beneficiaries don't have to pay capital gains on the increase in the stock's value that occurred during your lifetime.

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As you learned on Section 4.2.1, the tax rates on interest income, dividends, and capital gains vary and depend on the type of investment and how long you hold it. The table below shows you which types of investments are better in tax-advantaged and taxable accounts from a tax perspective—if you have a choice of accounts.

Investment type	Investments to hold in a tax-advantaged account	Investments to hold in a taxable account
Stock Mutual Funds or ETFs	Stock funds that pay high dividends (because the dividends are taxable). High-turnover (Section 5.4) funds (they produce capital gains, and short-term capital gains in particular), as fund managers trade investments. The gains are taxed at ordinary income rates. Mutual funds, because their managers have to sell shares to meet redemption requests, generating capital-gains taxes.	Stock funds that pay low or no dividends. Low-turnover stock funds, such as index funds. ETFs, which don't have to sell investments to meet redemption requests the way mutual funds do. Tax-managed funds, which invest with an eye toward reducing taxes.
Individual Stocks	Stocks that pay high-dividends, which are taxable. Stocks you trade frequently, which results in capital gains.	Stocks with low or no dividends. Stocks you tend to buy and hold onto, because you don't pay capital gains until you sell, and then they're long-term capital gains.
Bonds and Bond Funds	Regular bonds and high-yield bonds, because they produce current income taxed at ordinary income-tax rates.	Municipal bonds and bond funds; the federal government doesn't tax income (nor does the state tax bonds if you buy state-issued bonds in the state where you live).
REITs and REIT Funds	REITs tend to pay attractive dividend rates, and their income is taxed at ordinary income tax rates.

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Tip:

Stock dividends are taxed at a lower rate than bond income, so you're better off holding stocks that pay high dividends in taxable accounts rather than bonds or bond funds in those accounts.

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4.2.4. Managing Taxes in Taxable Accounts

Sometimes, you have to put higher-taxed investments into taxable accounts. For example, if you're saving for a short-term goal, stocks may be too risky, so you put your money in bonds or bond funds, or in a savings account. Or you may be saving for a goal that doesn't have a tax-advantaged account option. Don't worry. Although you shouldn't make investment decisions purely to avoid paying taxes, you can keep your investment taxes low with the following tactics:

• Buy and hold individual stocks and bonds instead of stock or bond funds. You don't pay capital gains on individual stocks and bonds until you sell them; fund managers may trade within stock or bond funds frequently, and you pay taxes on any gains from those trades. Sell individual securities in taxable accounts only to rebalance your asset allocation or because an investment hasn't panned out as you hoped.

• Buy municipal-bond funds or municipal bonds. If you want more bonds in a taxable account, purchase municipal bond funds. The federal government doesn't tax municipal bond income. In addition, you don't pay state taxes on municipal bond income if you buy municipal bonds issued by your state.

• Delay selling until the capital gains are long term. If you sell an investment before you own it for a year, you earn a short-term capital gain, which is taxed at ordinary income rates (for someone in the 25% tax bracket, that rate is 25%, versus the 15% for long-term capital gains). If you're close to the 1-year mark and the investment isn't in mortal danger, hold off on the sale until you pass the 1-year mark.

• Wait until the next calendar year to sell. If the end of the year is close, delay a sale until January. That way, you don't pay tax on the capital gain until the following year, which means you have a full year to use that money, for example, to earn interest on savings or invest in something else.

• Offset capital gains with capital losses. If you have capital gains and also have some losers you want to unload, sell the losers in the same tax year as the winners. Your capital losses offset your capital gains. This tactic is particularly effective for short-term capital gains, taxed at higher, ordinary income rates.

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Note:

If you have more than $3,000 in long-term capital losses, you can use those losses to offset long-term capital gains. However, if you don't have enough long-term capital gains to offset all of your long-term capital losses, you can deduct no more than $3,000 of a long-term capital loss in one tax year and must carry the remaining loss over to future tax years.

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