Three Things Every Tax-Savvy Investor Does
The Vanguard Group
To get and keep the most from your portfolio's returns,
follow these 3 steps:
Step 1: Max out your
employer-sponsored plan
Contributing to an employer plan provides a
double bonus. First, you can make contributions to the plan using pretax
dollars. This reduces the taxable income in your paycheck, so your taxes
will be lower. Second, investments in your employer plan grow
tax-deferred, which can significantly boost your returns in the long run.
Need convincing? Let's say you're in the 27% tax bracket. You save $2,000
a year for 40 years and earn a hypothetical 8% return on your investment.
Saving for your retirement needs in a tax-advantaged account can produce
substantially better results.
In the tax-advantaged account, you would have
accumulated $518,113 at the end of the period; in the taxable account, you
would have only $217,066.
As this illustration shows, taxes eat away at the investment returns in a
taxable account. The difference is even greater for investors in higher
tax brackets. The higher your marginal tax rate, the greater the tax
bite—especially when you consider state and local income taxes may
consume even more of your investment returns.
The information discussed is hypothetical. It does not
represent returns from any particular investment.
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Step 2: Contribute to an
IRA
You have 2 choices: a traditional IRA or a Roth
IRA. If you or your spouse has earned income, or if you receive alimony,
you're eligible to contribute to an IRA. Which type depends on your
financial situation.
A contribution to a traditional IRA may provide a tax deduction (depending
on your income and whether you're an active participant in an
employer-sponsored plan), but it always offers tax-deferred investment
growth. Contributions to a Roth IRA are never deductible, but your
earnings grow tax-free. Once you reach age 59½, your withdrawals
from a Roth IRA are tax-free, provided your account is at least 5 years
old. The contribution limit to an IRA of either type is $2,000 for tax
year 2001 and $3,000 for tax year 2002. The limit increases in stages
until it reaches $5,000 in tax year 2008. After 2008, the contribution
limit will be indexed for inflation. The allowable contribution is even
higher if you're age 50 or older—an extra $500 per year starting in
2002, and an extra $1,000 a year starting in 2006.
For a traditional IRA, you may have to pay a penalty if you make
withdrawals before you reach age 59½, if you contribute more than the
allowable limit for any year, or if you don't withdraw enough after
reaching age 70½. For a Roth IRA, you may have to pay a penalty if you
withdraw earnings before age 59½ or if you contribute more than
the allowable limit each year.
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Step 3: Put the right
funds in the right accounts
It's time to take asset allocation to the next
level: asset location. The usual advice is to put bond funds and
money market funds in tax-deferred accounts and to put stock funds in
taxable accounts.
In other words, keep assets that generate most of their total return as
income in your tax-deferred accounts. Assets that generate more of their
total return as long-term capital gains—which generally receive
favorable tax treatment—can be kept in taxable accounts.
Bond and money market funds generate most of their total return as
interest income, which (when distributed to shareholders) is taxable as
ordinary income unless it’s held in employer plans or in IRAs. Stock
funds, and particularly growth stock funds, tend to generate more of their
total return in capital gains.
The rule to keep bond and money market funds in tax-deferred accounts is
not absolute. Another way to shield income dividends from taxes is to buy
tax-exempt money market or bond funds, which are usually exempt from
federal income tax and often from state and local income tax. The higher
your marginal tax bracket, the more attractive tax-exempt bond and money
market funds become.
Another consideration is a fund’s tax efficiency. Since 2001, mutual
funds have been required to provide after-tax returns to help investors
understand the effect of taxes on returns. Some funds, such as
broad-market index funds, tend to be more tax-efficient than others. Still
other mutual funds are managed specifically to minimize the taxes their
shareholders will have to pay, which makes them logical choices for
taxable accounts.
When deciding which mutual funds to put in a taxable versus a tax-deferred
account, don’t use tax-efficiency percentages in isolation. Also
consider the magnitude of the returns likely to be lost to taxes. In some
cases, it might make sense to put a fund having a higher tax efficiency in
a tax-deferred account.
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