Making Your Money Work

Taxes can take a significant portion of your investment gains. If the tax consequences of your investments are ignored, you’re likely to pay more in taxes than necessary. Be sure to consider the tax implications of any investment before allocating your investment dollars. Taxes on earned interest, dividend income, and capital gains all reduce your investing profits.

If you haven’t been taking taxes into consideration, it’s never too late to start.

Invest your dollars in the following tax-advantaged accounts (in order):

  1. Any 401(k) or 403(b) up to the employer match limit. This is the most tax-advantaged account available to most investors. Companies commonly match the first 3-4% of your contributions. 
  • With employer matching, it’s a guaranteed 100% return on those contributions. You also lower your taxable income.
  • These two advantages provide “free money” and are the reason why these retirement accounts are the first step. Reach your match limit before allocating funds to another other option.
    • Even if your employer only provides minimal investing options, a retirement account with matching is an ideal first step.
  1. Traditional or Roth IRA. With traditional IRAs, you can reduce your taxable income. With a Roth, your earnings are tax-free. Do the math for your situation and determine which makes more sense. There are certain limits based on income.
  2. Make additional 401(k)/403(b) contributions until the limit is reached. After making the maximum contribution to an IRA, the next logical step is to make the maximum contribution to your employer-sponsored retirement accounts. 
  • For those under 50, the maximum is up to $18,000.
  • For those 50 and older, the maximum is $24,000.
  1. 529 account. Contributions are after-tax, but the gains are tax-free when used for qualifying expenses. It can be a mistake to fund your child’s higher education before contributing to your retirement. You can get a loan for college, but not for retirement.
  2. Health savings accounts. A health savings account can lower your medical bills and your tax bill. The contributions are tax-deductible and the earnings are tax-deferred. Withdrawals are tax-free when used for qualified expenses. 
  • Unlike a Flexible Spending Account, you can roll the money over indefinitely from one year to the next.
  1. Taxable investments. Have you exhausted the available tax-advantaged investments? Now it’s time to invest in taxable investments, but with tax-efficiency in mind.

These same steps would be taken for your spouse, too. Of course, if you don’t have a need for a 529 account, there’s no reason to invest in one. If you have short-term needs, such as saving for a house, taxable investments might be further up on your list. Taxes are always the primary concern.

When utilizing taxable investments, make an effort to invest in the most tax-efficient investments. Keep in mind, also, that the least tax-efficient investments can still be held in tax-advantaged accounts like 401(k) or other retirement accounts.

Common investments listed from most tax-efficient to least:

  1. Tax-exempt municipal bonds. The earnings generated by municipal bonds are generally exempt from federal income taxes and are often exempt from state taxes.
  2. I/EE savings bonds. The interest earned from various types of bonds is tax-free if used for higher education expenses.
  3. Tax-managed mutual funds that focus on stocks. These funds stick to stock investments, but do so in a way to minimize the tax implications. This type of mutual fund is becoming more common.
  4. The majority of index funds that focus on stocks. By avoiding bonds, these index funds are relatively tax-efficient.
  5. Growth stocks. Growth stocks rarely pay dividends. The profits are reinvested in the growth of the company.
  6. Value stocks. The share price of these stocks is slow to change. Dividend distributions are common and subject to a higher tax rate for most investors. Value stocks are less tax-efficient than growth stocks.
  7. Balanced mutual funds. The inclusion of bonds in this style of mutual fund creates greater tax consequences.
  8. REITs (Real Estate Investment Trusts). These investments are among the least tax efficient. The tax situation is relatively complex behind the scenes. REITs are trusts and subject to tax at the trust level and at the corporate level before distributions are made to the unit holders (investors). 
  • Dividend payments are typically taxed at the investor’s top marginal tax rate.
  • The situation is far more complex than depicted here. The bottom line is that REITs are inefficient from a tax perspective.
  1. Taxable Bonds. Bond interest and dividend payments are taxed as regular income. If you want to invest in taxable bonds, it’s best to limit their inclusion to tax-advantaged accounts.
  2. High-Yield Bonds. These bonds are considered to be less efficient due to their higher yield. The higher level of risk indirectly contributes to their lower tax-efficiency classification. You’re unlikely to have access to these investments in your 401(k).

If you’re in the lower income brackets, bonds can be a more tax-efficient investment than stocks. Interest income is generally taxed at your income tax rate. The capital gains tax rate is generally lower than the income tax rate for those with higher earnings. It always pays to do the applicable math and determine which investments are most tax-efficient for your situation.

However, taxable accounts aren’t all bad.

Taxable accounts have two primary advantages:

  1. The ability to harvest losses. If you purchase mutual fund shares within a 401(k), you can’t write off the losses you suffer. In a taxable account, it can be advantageous to take your losses and reduce your taxable income by that amount.
  2. The more tax-advantaged the account, the lower the level of flexibility you’re likely to find. Consider all the investments options available in a standard brokerage account. The opportunities are abundant. You also have the ability to cash out of a taxable account and put the money in your pocket without expensive penalties.

Most investors fail to fully account for the tax implications of their investing activities. You would be wise to maximize contributions to tax-advantaged accounts prior to investing in taxable investments, provided it supports any short-term goals. The greater your income, the greater the benefits provided by tax-advantaged accounts.

Consider taxes when distributing your investment dollars. When evaluating the return on your investments, taxes can have a significant impact. It’s important to be aware and make informed decisions.

About the Author

Lorene Collier Purcy is a Certified Financial Social Work Coach, Creative Wealth Educator, President & CEO of Mindset Matters Consulting & Education LLC, an enlightenment organization, that partners with schools, youth groups, churches and communities to educate, equip and empower today’s youth from all walks of life to take control of their future through properly managing their money and becoming socially connected to the real world. Lorene is also the Founder of Savvy Chicks Rule, empowering women on how to rethink and reevaluate their beliefs, thoughts and attitudes about money. When it comes to Money Matters Lorene is the Money Maven individuals, groups and companies choose to experience financial victory!

Leave a Reply 0 comments