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Have you ever looked at your paycheck and noticed how much the government is taking out of it? If you have looked at it, you are probably aware of how much of a wealth killer income tax is. Taxes can really put a drag on the growth of your investments. This is why it is important to practice tax efficient investing.
How Taxes Work for Investments
If you have a roth IRA or a traditional 401k, you don’t have to worry about taxes at all unless you withdraw prior to the eligible age for withdrawal of funds (currently you are eligible to withdraw without taxes at 59 1/2 years old). If you have any other account such as a traditional IRA, but if you have an account where you will have to pay taxes on earnings and withdrawals, you will save a lot of money in the long run by being selective in the type of investments you make for these accounts.
If you have a taxable account, you will either be taxed at 0%-20% for your investments or you will be taxed at your normal tax bracket (most people’s normal tax bracket is 20% or higher). Capital gains earnings (these are earned when you or a fund sell shares and make a profit are taxed) are taxed at your normal tax bracket. If you or your fund sell a lot of stocks and bonds, you could pay a heavy price because a larger amount of your gain would be taxed. Because of this, you want to avoid having actively managed funds in your taxable accounts. You also want to avoid having funds that would be taxed at a normal tax bracket such as REITs. You want to have REITS in tax advantaged accounts instead.
If you have any questions about these issues, you can talk to a certified tax adviser or you can search for more information online. To make your life easier, however, I will show you how to invest tax efficiently by telling which which types of funds to have in your investment accounts (keep in mind that in order to qualify for lower tax rates, you need to hold an asset for at least a year).
Tax Efficient Investing
Below I will list the account types and tell you which type of assets will save you money on taxes.
Roth IRA/Traditional 401k/Roth 401k/Traditional 401k
All of these accounts are tax advantaged so you can invest in any asset you want to in these accounts. If you have good low-cost mutual funds and Real Estate Investment Trusts, these accounts are a great place to invest in them.
Taxable Brokerage Accounts
In these taxable accounts, you want to stick with passively managed funds such as Index Funds and Exchange Traded Funds. You can also invest in individual stocks. For bonds, you want to hold municpal bonds because they are exempt from federal income tax (they can be subject to state income tax, however, but it is better than being hit by taxes twice when you invest in a taxable bond).
With taxable accounts, you also run the risk of having to fill out tedious forms such as a Schedule K-1 form (a common culprit for having to fill one of these out are Municipal Limited Partnerships); however, most index funds and exchange traded funds will not require a K-1 Form. If you have any questions about taxes, contact a tax adviser or you can call your brokerage to make sure you won’t have to fill out any additional forms aside from the typical 1099 form that investors with taxable investments fill out.
Tax efficient investing is very important. If you do not do your due diligence, it could cost you a significant portion of your savings for retirement.
There are many reasons to get out of debt. In this article, I will give five reasons why you should get out of debt.
Debt is a Wealth Killer
On average, investment portfolios return 6-12% depending on asset allocation. Many people have loans or credit cards that have interest rates north of 7% (some credit cards have interest rates of around 30%). Would you invest in any asset that loses 7-30% a year? If not, why should you borrow money for an extra 7 to 30 cents per dollar? This may not sound like much, but if we are talking about a $30,000 loan at a 10% annual interest rate, that is $3,000 a year in interest. If you are paying that off over a 3 year period, that is $9,000 dollars that could have gone to investing. $9,000 in a portfolio that yields 4% in annual dividends and bond distributions would amount to $360.00 of passive income a year. In 10 years that would amount to an extra $3,600.00 in your pocket. Would you rather make money or lose it? The answer is obvious.
Paying Off Debt Frees Up Cash for Fun Stuff
Do you wish you could have more money to spend on yourself? I agree with Ramit Sethi when he says that we should allocate 20%-35% of our budget for guilt-free spending money. Unfortunately, many people cannot do this because they are so far in debt that they have no excessive income. You could put more money in savings or invest more, but most of us would like to live life a little bit on the way. After all, tomorrow is not guaranteed. If you have a loan where you have to pay $150.00 a month, that is $150.00 that you can’t invest or spend on yourself. Why give the money to someone else when you can make that $150.00 work for you?
Debt is Stressful
Do you like being stressed? Unless you are glutton for punishment, the answer is probably no. According to HomeServe USA, about half of Americans are living paycheck to paycheck. The New York Federal Reserve has said that much of this is due to debt. Who wants to live a life where the next unanticipated emergency would be a financial catastrophe? I cannot think of many situations that could be more stressful.
Having No Debt Gives You More Options
Do you like your job? While I advocate viewing your job as an asset that helps you to get to where you want to be, some jobs are very unpleasant. In fact, if your job makes you depressed, you could have better luck with getting another job if you have no debt. After all, if you have no debt, your income requirements are lower. This could give you the freedom to do something else that you like better even though it is not as lucrative. Making money is important, but our mental well being is more important.
If you lose your job, your emergency fund will last longer if you do not have to pay down debt. You might even be able to get by if you donate plasma and drive for Uber if you suddenly find yourself without a job. Your alternative options to being employed become broader when you don’t have to worry about keeping up with your credit card and loan payments.
Would you like to be able to pay cash for a car? Having no debt makes it easier to save up a large amount to buy a car. I’ve never had a car payment in my life, and I can tell you that I enjoy my vehicles more because of it. A shiny Mercedes Benz is not as fun when you are dragging around a $500.00 a month car payment. The first step of financial independence is to pay off debt as quickly as possible.
You Have a Moral Responsibility to Be Wise with What God has Given you
God requires us to manage our money wisely (1 Timothy 5:8, Proverbs 21:20, Proverbs 13:22, etc). We are to be able to manage our money so that we can provide with our family. We also should also invest in our children’s future. We should also be prepared to give to others. It is harder to do all of these things if we are in debt. Since it has been commanded of us, we must be good stewards of what God has given us.