It’s no surprise that taxes are going up next year. How much? No one really knows exactly, but at worst case Bush’s 2001 and 2003 tax cuts will completely disappear. If Congress does not act the Bush tax cuts expire at the end of this year. This may include my often-loved taxable rate of 15% on dividends. In addition, depending upon your situation, taxes will increase even more in the next 3-5 years by various new laws. Historically taxes are at some of the lowest levels, and with budget deficits it has only one way to go, and that is up! With all of this in mind, it’s wise to legally avoid or delay taxes as much as possible. After all, most people pay one third of their income in taxes. So when it comes to investing for the long haul, it’s always important to consider taxes, as the capital gains minus taxes can be significant. The Bogleheads are also a big fan investing tax efficiently, and believe this is an effective way to invest.
Tax Efficient Investing Order
When investing on an annual basis, it’s best to fill up your accounts in the following order:
- Your employer’s 401k/403b up to matching amount
- Invest the maximum into a Roth IRA
- Back fill your 401k/403b to the maximum amount
- Invest in a 529 Account
- US I Savings Bonds
- MLP and Muni Bonds
- Taxable Investments
If you have a spouse, you would also do the same order to their accounts (if all options are available) as you would do for yourself. Based upon your needs and goals, this order may slightly vary. The basic gist from this list is to invest first in items that give you the greatest tax reduction or tax delay. Let’s go over the list one by one.
1. 401k/403b up to employer’s matching amount
With a 401k you usually get two forms of “free” money. Your AGI (Adjusted Gross Income) is lowered which effectively lowers your income at least for federal taxes. The other factor is most companies match 3-4% of what you invest. This is the reason to invest in these first and contribute at least up to what the employer matches. Granted some employer retirement plans suck. Some plans do not have cheap and indexed based mutual funds (i.e. Vanguard), or have only a limited selection of funds.
2. Invest the maximum into a Roth IRA
As of 2010 the maximum for a Roth IRA is $5,000 per year. Invest the maximum amount. Open up an account with a firm that offers low transaction fees like ShareBuilder. Roth IRAs have quite a few advantages over a 401k/403b or traditional IRA. A traditional IRA reduces your AGI, but must pay taxes when you withdraw. A Roth IRA on the other hand, is invested after tax, but withdrawals are currently tax-free. The other nice aspect of any IRA is the potential to invest in pretty much any type of investment. From physical gold, to real estate (not REITs!), to Lending Club, and of course more traditional investments. A Roth IRA is much more flexible than any 401k or 403b. It’s wise to use IRA accounts to help create a proper asset allocation. Meaning if your 401k offers a poor choice in mutual funds or doesn’t offer specific funds (i.e. international stocks), your IRA account should be used to fill in that gap.
3. Back fill your 401k/403b to the maximum amount
After filling up your Roth IRA account for the year, you are usually best to go back and back fill your employer’s retirement account to the maximum.
4. Invest in a 529 account
If you have children or have future higher education needs yourself, it’s best to invest money into a 529 plan. Money invested is after tax, but is tax free when withdrawn for qualified higher education. In some states (New York in my case) gives a state tax deduction for investing. If you don’t have any needs in this area, you can skip this step. Unfortunately many parents save for their children first, instead of taking care of their retirement plan first. Retirement plans should always be funded first since you cannot take a loan out for retirement. In addition, there are situations in which IRA accounts can use for higher education without penalty.
5. US I Savings Bonds
As mentioned previously, I am a big fan of US Savings I Bonds. I think they are a great way to invest some money that’s indexed to inflation, and yet be tax differed while holding the bond. They can serve multi-purposes in your portfolio, and can be used for higher education needs tax-free. At minimum, invest the maximum electronic amount (currently $5000) into I Bonds annually.
6. MLP and Muni Bonds
This is an optional investment as it depends upon your income level, and how complex you want your tax situation. Though, MLP are a great way to get a steady return, and yet most of it be tax differed. The disadvantage to a MLP is they are much more complex to deal with when filling your taxes. It is usually recommend to hire an accountant to properly file your taxes when owning a MLP.
Investing in muni bonds depends upon your income level and the state you live in. High income (you know the one’s Obama vilify) are usually the best to purchase these bonds. If you have enough money ($250k+) you can directly purchase these bonds, if not you are best to stick with an index-based mutual fund or ETF to get proper diversification.
7. Taxable Investments
After every other item has been filled, only then it’s time to invest in taxable accounts. Of course if you have other goals than retirement, and higher education (i.e. buying a house or rental property) you may want to push this item higher up the list. When investing in your taxable accounts it’s typically best to make sure they are still tax efficient. This means investing in mostly stocks, ETFs, index based mutual funds, and tax efficient mutual funds. If you are using it as part of your retirement planning, it should be considered as part of your asset allocation. This means for example, putting stocks with no dividend into your taxable accounts.
Summary
Keep in mind like any part of investing, one should not invest solely for tax avoidance. Do not miss investment opportunities just because it’s tax inefficient, though it should always be considered with your planing. Though as your different types of investment accounts grow, you’ll be able to put the new asset class into the most appropriate account.
This is a good summary of the tax advantages of each of these accounts. Over time, I have become less enamored of most of these accounts due to all of the strings attached to get the tax advantages. Right now I primarily invest in taxable accounts. The range of investments in taxable accounts is large and many of these have tax advantages of their own.
Keep in mind that 401Ks and 403bs are not a free lunch every dollar is eventually taxed. If you have a large enough estate, you get hit twice first with the face value of the account for the estate, then you pay taxes on the proceeds. In my mind tax deferral is not enough of a carrot.
Roths are really a free lunch. It has the tax deferral plus tax free withdraws. Not only that you can withdraw your contributions at any time. Very flexible.
Mike
"withdraw your contributions at any time." Technically you must be older than 59 1/2, but there are other exceptions.
You are correct about tax advantages and becoming less enamored with them. I also have a decent amount in taxable accounts as it's much more flexible for other purposes.
The Roth IRA free lunch, not sure how long it will last with government deficits. Hopefully they will ONLY start with new money, not existing Roth IRAs. If they did somehow make Roth IRAs taxable, the general public would be pissed though.
Cool List. Where would you put reinvesting in yourself on that list? In your business? In physical real estate? etc.
Reinvesting in yourself? You mean higher ed? It's on there. Business and real estate can be great with taxes. It really depends upon your specific situation and hard to put on a list like this and then put in a specific order.
For example, real estate has a 1031 exchange in which you won't pay capital gains if you upgrade to a bigger investment property.
Also as you mentioned before a SEP IRA (an IRA within a business) could be placed #1 with 401k/403b because it's pre-tax of business or personal income.
It's too bad the 401K contrib limit is SO LOW at $16,500, and once you make over 100K you can’t contribute to an IRA.
A shame.
Yes agreed but hey if we have roaring inflation the limit will go much higher right?
Hope so. Hey look, the Yakezie gravatar works.
Thanks for the list!
For high tax-bracket families, how would your list change? Roth IRA is inaccessible at those income levels. Govt bonds are up to the 10K limit per person. How would you rank the muni and MLP versus buying investment (e.g. rental) properties and depreciating them ?
HI Laura,
I would speak to a tax specialist and/or accountant. This is meant as a basic guideline as everyone’s situation is different.