How would you like to get a higher return on your investment portfolio without taking on any more risk? Believe it or not, it’s easy to do. All you need to do is set up your various investment accounts to take full advantage of the current tax rules. With taxes at the highest rates in recent memory, tax-wise investing is even that much more valuable to you.
The first step is to start maximizing your contributions into your retirement accounts such as IRAs, 401(k) and 403(b) accounts, and self-employed retirement plans. Amounts contributed to these accounts are generally tax deductible and always grow tax deferred unless you go with the Roth version of the retirement plan. That means you won’t owe any taxes on the investment earnings until you begin withdrawing money from your pre-tax accounts. Each year you can contribute quite a bit of money into these accounts – up to $18,000 into your 401(k) or 403(b) plan this year, or up to $53,000 into your self-employed retirement plan. Higher limits apply if you’ll be 50 or older by December 31, 2015.
It Adds Up!
To illustrate the power of tax-deferred investing, let’s assume you have the choice of contributing $10,000 to a 401(k) plan each year for 25 years, or you can take the $10,000 as a bonus, pay the applicable taxes, and then invest whatever’s left.
OPTION A: If you choose the 401(k) plan route, your account will grow to be worth more than $1,000,000 after 25 years, assuming a 10% rate of return.
OPTION B: If you choose to pay taxes along the way, your investment portfolio won’t even grow to $500,000 over the same period of time.
Next, take a look at your tax-free investment opportunities. These include Roth IRAs for your retirement and 529 Accounts for your child’s education. You don’t get a tax deduction for contributions made into these accounts, but you’ll owe no taxes on amounts withdrawn, as long as certain conditions are met.
Investing in tax-favored accounts is only half the battle. It’s also important to give some thought as to the specific investments you’ll hold within your taxable accounts and your tax-advantaged accounts.
As a rule of thumb, try to hold those investments that pay out the least amount of interest and dividends within your taxable accounts. Examples of tax-wise investments for your taxable accounts include index funds, ETFs, individual stocks, and “tax-efficient” mutual funds. These investments generally pay little or no dividends each year. Remember, while the tax rate on interest and dividends can be as high as 43.4% this year, the long-term capital gains tax rate for most individuals is capped at 23.8%, as long as the investment is held for more than 1 year before being sold.
You might also consider switching some of your fixed-income and money market investments to tax-exempt bonds, bond funds and money market accounts. Since the earnings on these investments generally isn’t subject to federal income taxes, this strategy could help you increase the after-tax return on your fixed-income investments. Most of the mutual fund companies offer a variety of tax-exempt investment choices.
Finally, in your tax-advantaged accounts, hold those mutual funds, bond funds, and other investments that historically pay out large dividends each year, since you aren’t being taxed on the investment earnings within these accounts.
By maximizing contributions to tax-advantaged accounts, and giving some thought to the investments you hold in each of your accounts, you should be able to increase the after-tax return of your investment portfolio without taking on any more risk.