Tax-advantaged investments, such as a 401(k) or an IRA, are a great way to increase your long-term returns. However, you have to invest in the right things.
The most tax-efficient investment is one that appreciates rapidly and is taxable at the capital gains rate, which for most investors is 15% or less. If you buy a stock that keeps going up and pays no dividends, then when you sell it youâll pay tax on your profits at that low capital gains rate rather than at your ordinary income tax rate, which could be as high as 35%. So if your marginal tax rate is higher than 15%, itâs better to invest in things like stocks and stock funds than in bonds and bond funds.
In my experience, this is the most misunderstood part of investing. Itâs easy to see that if your investments pay big capital gains, youâll pay a big tax on them; by the same token, if you donât make big gains, you wonât pay much tax. Using this rule, itâs easy to think that if you cut your tax by investing in tax-free bonds, then youâre getting free money from the government.
How could anyone be so foolish as to leave free money on the table? But what if our definition of free money isnât perfect?
My accountant has always made me uneasy. Not that I distrust her; in fact, I trust her very much. But she has a habit of asking me questions like: âWhatâs the most youâd be willing to pay for something?â or, even better, âHow much do you hate paying taxes?â
I usually try to give her the benefit of the doubt and make reasonable guesses at these questions, but Iâm usually wrong. When I am offered a new investment opportunity I want it to be tax-smart. But here are the two mistakes I often make:
Mistake #1
Income tax is now a larger percentage of the average personâs income than it has been for generations, and yet people are paying far less attention to it. Itâs not that theyâre ignorant of the fact that they have to pay taxes; itâs that theyâre ignorant about how to make those payments as painless as possible.
The first step in making your taxes painless is to understand the tax system. There are several reasons why you might not want to do this:
You can pay a lot of money to a professional accountant, but youâll still be at the mercy of an opaque system whose inner workings even professionals donât fully understand. You can claim ignorance, but you will still be subject to rules you donât know and penalties you didnât expect. If you do decide to invest in learning about taxes yourself, this article will help get you started.
The first thing to learn about taxes is that there are three major categories into which all taxes fall: income tax, sales tax, and payroll tax. Income tax is just what it sounds like: money taken out of your paycheck before you get it. Sales tax applies when you buy goods or services.
Simple tax planning can help you boost your returns without increasing your investment risk. It just takes a little time and a few extra forms at the end of the year.
Taxes are due April 15, but financial records that support them are frequently needed by then. So begin at the end of the year to gather documents like receipts for charitable contributions, medical expenses, travel, and business expenses.
If your income is low enough, you may be able to deduct some losses from gambling (on horse racing or slot machines) or bad debts from lenders whose credit quality was poor.
If the stock market is a good deal for investors, itâs a great deal for the U.S. Treasury. The market has been soaring over the past 20 years, and the federal government has gotten an unusually large share of those gains.
The Congressional Budget Office recently released historical figures for the after-tax return on investment in the S&P 500 index from 1916 to 2011. Over that period, the stock market has returned an average of 6.3 percent a year after inflation, or just a hair under 10 percent before inflation.
Whatâs striking is how much of those returns went to Uncle Sam, not to you and me. The government taxed away 28 percent of those returns in 2011, more than twice as much as it did in 1986.* In other words, if I had invested $1 million in 1986 and gotten a 10 percent return every year since, by 2011 Iâd have been left with $10.86 million, but I would have paid $3 million in taxes on that money** â leaving me with less than half as much as I would have had I put that money into a bank that paid no interest at all.
The best investment you can make is in yourself. You can do that by learning new skills and knowledge. It is very unlikely that your ability to generate income will ever exceed your ability to learn new things.
As you get older, this will become even truer. The odds are good that the most money you ever make will be when you are in your thirties or forties. So if you canât save at least 10 percent of what you make during that period, you shouldnât expect to retire comfortably.
However, saving isnât the only way of increasing your investments: there is also investing in other companies. When we say âinvesting,â we mean buying ownership of a company, and letting it pay off by selling things and making money for you. This means stocks and bonds and such. These can be risky too, especially since they tend to go down as well as up (although not nearly as much). But if you know how they work, they can boost your return by quite a bit.