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.