I realize that for most of us taxes is a pretty boring topic, but a couple of distinctions here and there and you can save thousands over your lifetime and probably hundreds of thousands if you are a saver and educated investor. It’s always amazed me as a Financial Planner how often people never make the link between their taxes and their investing portfolio. Many people feel that investing is one thing and taxes are another and fail to plan properly. The real beauty is that most tax strategies are generally risk free and it’s like free money as opposed to investment strategies where we have to manage risk.
However, you will find that good tax strategies are similar to investment strategies in the fact that they are balanced, and you make decisions based upon your situation. So let’s identify some common tax mistakes and make certain that we are avoiding them.
Not selling because you have to pay taxes. As a Financial Planner and Tax Preparer, I have seen this way too many times. It's unbelievable how many people would rather hold a stock until it’s extinction than pay the 15% capital gains tax. Pay some tax, take a profit and diversify, because there are no sacred cows out there.
Keeping bonds in an IRA or tax sheltered accounts. Pretty simple, but most people fail to do this. Bonds pay interest which is taxed as ordinary income, as opposed to the favorable 15% tax rate for capital gains and dividends. Ordinary income for most is usually at least 25% and in many cases higher. Making tax sheltered accounts like IRA’s and 401k’s the best home for Bonds.
Keep stocks and capital investments in accounts that are subject to capital gains. This compliments my last point. With a 15% capital gain and dividend rate, why not? In addition, if you have losses you will be able to sell and harvest the losses to offset future gains. Remember if you have all of these in a 401k/IRA that’s OK, but if when you have money outside the IRA you generally keep the bonds in the IRA and the stocks outside.
Keep foreign investments out of tax deferred accounts in order to take advantage of the foreign tax credit. Foreign countries withhold tax on investments in their countries, and you would need to file a return to get the money back. This is not practical, so the IRS allows you to claim a credit to get some of these foreign withholdings back. You cannot get the credit in a tax sheltered account. Again, it's ok to have them in a 401k/IRA, but when you can chose better outside because of this.
Take advantage of a Roth IRA and look to invest the Roth a little more aggressively. Too many people are not taking advantage of the Roth IRA and the benefits are incredible. Look to invest in the Roth more aggressively due to the fact that there is no tax and seeking higher returns in an account that is tax free makes a lot of sense.
On the opposite spectrum, the Roth is not a bad place to start an emergency fund. In a Roth IRA you can always draw out your contributions with zero tax. Invest them conservatively in things like a money market and once your emergency fund is 6 – 9 months of monthly expenses start investing more aggressively. Every year you do not put money into a Roth is a lost opportunity! Ideally though, you want to have your Roth fully invested, and have a real emergency fund.
In conclusion, these are just a couple of mistakes I have seen people make and there are more depending in person’s situation and estate planning goals. The main point is that the allocation of your investments and assets should take into consideration taxes, and seeking out that answers to the question will save you a lot of money over the long run.
Don’t forget to check out our courses and you will be able to ask questions that pertain to you own situation!
Bob O’Brien
Sr. Instructor
www.mywealth.com
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