Investing is the act of tying up money today into an investment with the hopes of getting a greater amount of money tomorrow. There are two main ways to achieve that “greater amount”. One is that your investment grows in value. The other is that you reduce the amount of taxes paid on the returns. When you look at an investment, you should always consider your after-tax return.
Learning about tax advantaged accounts is kind of like watching grass grow. It’s not very exciting but if you could put a time lapse camera on it and watch it in fast forward, it’s awesome to see the growth in action. While this may not be exciting, think about it this way, you can either work harder and longer to save up for retirement or you can spend some time educating yourself now to see how a little planning can make a big difference. Working smarter, not harder as the adage goes. I will list some of the tax strategies that I am aware of in order to assist in your planning.
401k vs 403b
The most common way to reduce your tax bill is contributing the maximum amount to your 401k or 403b. Both are essentially the same thing. 403b plans are available to people working in a school district, religious group, or not for profit. 401k plans are more widely known and available. In both cases you will invest your money pre-tax, capped at the set limits. Some employers match your retirement savings which makes if even more enticing. Not investing would be turning down free money if your company matches. Now you will have to pay taxes when the money is taken out, but your tax bracket should be lower and your money grows tax free until then.
A traditional IRA, as opposed to a Roth IRA, is similar to the 401k and 403b mentioned above in that money is taxed when withdrawn. If your income is below the threshold and you are not covered by a retirement plan at work, then the contributed money is tax deductible. Also, the amount you can contribute is less than a 401k which makes it less ideal. The nice thing about a traditional IRA is that you can still contribute money if you are maxing out your 401k and your income is above the limits. Contributed money is not tax deductible, but you will enjoy the benefits of tax-free growth until the money is withdrawn. When you withdraw money, you will only pay taxes on the return, not on any money contributed post tax. Keep good notes to make it easier later in life on what was pre-tax vs post-tax money.
Another point to mention on IRAs is that you can invest in just about anything you want. 401k/403b plan usually have ten to twenty options to invest in. Some of the options are expensive with high management fees which you should always be careful of. With IRAs you can invest in stocks, bonds, funds, ETFs, just about anything. For the more adventurous investor you can open a self-directed IRA which has the same rules as an IRA but it will allow you to invest directly in real estate, private mortgages, precious metals, art, stamps, the list goes on.
Now that we know about the more well know tax advantaged plans, let’s learn about the holy grail, the Roth IRA. Here’s why it’s such a great investment tool.
- Money goes in post-tax but comes out tax free after the age 59 ½. This can be important to people who are concerned about their tax rate being higher in the future.
- Heirs who may inherited a Roth IRA do not have to pay income tax, although estate taxes may apply.
- There are no mandatory withdrawal rates. In a traditional IRA you must withdraw money at the age 70 ½. This does not apply for a Roth IRA.
Like traditional IRAs there are income limits that may exclude you from contributing to a Roth IRA. If your income exceeds these limits, you cannot contribute money directly to a Roth IRA. But there is a backdoor trick that is available. The way this works is that you can convert a traditional IRA to a Roth, but you must pay taxes on any money that you have not paid taxes on yet plus any positive investment returns that you have earned. The amount withdrawn and not yet taxed will be added to your income for purposes of figuring out what tax rate you will pay on it according to the income tax bracket you fall into. It may even raise you into the next tax bracket.
In order to convert money from a traditional IRA to a Roth, your current tax bracket and projected future tax bracket are the deciding factors. Let’s say you are in the highest income tax bracket today, then it won’t make sense for you to convert a traditional IRA to a Roth as your tax bracket will likely be lower in the future. But if you are having a low-income year such as a job loss, starting a new business, or have large realized losses that lower your income into a low tax bracket then the conversion may make sense.
If you made it this far in this post you are either having a hard time falling asleep or are really excited about saving for retirement. Here’s one that can really make a big impact on the amount you are able to put away. If you are self-employed or have a side business, you can contribute up to 56,000 as of 2019 into a SEP IRA. The rules are a little bit trickier so I recommend reading the ira website, but generally you can contribute 25% of your net income or 20% of net income if it’s a single member LLC (sole proprietorship). The cool part is that you can contribute to both a 401k and a SEP IRA in the same year, if you have a 401k plan at work and some type of side business. SEP IRAs can be set up at most brokerages houses such a Fidelity and or Vanguard.
Short vs Long Term Capital Gains & Qualified Dividends
For those who have money to invest after maxing out all of your tax advantaged accounts, that’s awesome. You are rockstars! Maybe literally since they make a lot of money. But how should you think about investing in a taxable account? Simply put the longer you hold onto your investment, the more tax advantaged it is. For starters, you want to hold onto your investment for at least a year. After 1 year then you get taxed at the long-term capital gains tax verse less then a year it gets taxed as ordinary income, which is generally higher.
The not so obvious reason that you want to hold onto your investment for as long as possible is the tax deferred nature of the growth. We’ll use some round numbers to explain. Let’s say you start with a 1,000 investment that doubles. If you sold you would have to pay 500 at an assumed 50% tax rate (again, using round numbers for simplicity). Since you have not sold, you don’t have to pay taxes on the gain. If the investment is growing and/or paying a dividend at a rate of 10%, you are earning that rate of return on what would have been paid to the government for taxes if sold. The 500 dollars that would have went to the government is earning you a 10% return. It’s almost as if the government is giving you an interest free loan on the taxes that you will one day have to pay.
Another benefit of holding a stock for a longer period of time is that the dividends get taxed at the long-term capital gains tax. This is called a qualified dividend. The holding period is generally short at 60-90 days. There are other requirement to be classified as a qualified dividend such as being paid by a corporation in the US.
One more thing to mention on taxable accounts. You want to be careful not to invest in certain things. REITs is one of them since they pay high dividends that are not qualified and taxed as ordinary income. The general rule is to avoid ordinary income on investments as that is likely to be a higher tax rate than long-term or qualified dividends.
Master Limited Partnership (MLPs)
Now we are getting in the swim at your own risk end of the pool. MLPs are investment vehicles that generate income from natural resources and real estate. They combine the benefits of a publicly traded security with those of the tax benefits of a partnership. They are tax advantaged as the higher dividend rates they pay are in part tax deferred. Part of the dividend, sometimes north of 10%, are classified as a return of capital and you do not pay taxes until you sell. They also offer estate planning benefits as the investment transfers to your heir at the current market value of the security for tax purposes, thus all the tax deferrals go untaxed.
The downside to an MLP is that it comes with a schedule K-1 each year that you will have to pay your own taxes on. If you own a lot, you may even have to file taxes in different states if you exceed certain thresholds. Do not buy an MLP in a non-taxable account such as an IRA because the income received from an MLP can trigger certain UBIT (Unrelated Business Taxable Income). This is a more complicated investment and should only be used by people who have thoroughly researched and understand what they are buying. (Wow, this sounds like a disclaimer at the end of drug advertisement on television.) However, I did want to mention this as some people may not be aware of the tax benefits they offer.
529 Plans – College Savings Plans
While this is not a retirement plan, it does offer awesome tax benefits when saving for college. Money contributed to 529 plans are not tax deductible (with exception for states such as New York State income tax) but any returns are tax free when used for qualified educational expenses. You do not have to open a 529 plan in your state, but some states offer tax breaks. Also, watch your fees as some state plans are expensive while the NY 529 plans offer very low expense ratio vanguard funds.
Are you still awake?
Either you love this stuff or it puts you to sleep. Either way it’s important. While my description of the different tax efficient investments in this post are not as thorough as they can be, I am trying to find a balance between keeping your attention and giving you one spot for different tax advantaged investments. And if you don’t think taxes matter, look at the image above. It shows how money will grow tax free vs paying taxes at 25% per year for 50 years. At a 6% rate of return, your money will be double of what it would be in a Roth IRA vs a taxable account that is traded actively. Yes, I know 50 years is a long time, but it’s a huge difference when you consider you didn’t take any additional risk in your investment, you were just smart and planned ahead.
On a Side Note
As you may have noticed the majority of the links are to the irs.gov website. The website is surprisingly well done and informative. Plus, the added bonus of being sure you are getting the right answer instead of reading someone’s blog and hoping they know what they are talking about 😉. But in all seriousness, I am not a tax professional, just someone who loves to be efficient with his money. While I believe everything in this post to be correct, please do your own research to be certain.