Principles of Sound Investing
Federal tax law provides many tax breaks for investors. Among the most important are tax-sheltered retirement plans giving favorable tax treatment to money that is set aside for later years. Participants may fund the plans through payroll deductions, as in 401(k) and 403(b) plans, or through personal contributions, as in IRAs. In most plans, the contributions and the investment returns they earn are exempt from taxation until they are withdrawn in retirement. There are also tax shelters for college saving: 529 plans and Educational Savings Accounts.
The tax shelters discussed in this section are perfectly legal strategies allowed by tax law in order to encourage saving. They shouldn't be confused with tax shelters of questionable legality, such as transactions designed to create an appearance of capital losses where no real losses have occurred.
Advantages of tax-sheltered investing
To appreciate the value of tax-sheltered investment, think of it as an interest-free loan from the IRS. You get to hold onto some capital that you would have paid in taxes, make money by investing it, and keep most of the investment earnings. Better still, many employers will match a portion of the employee's contribution to a tax-sheltered plan, which results in an instant high return on the investment.
Tax-sheltered retirement plans usually offer a number of investment options, although some plans are far more flexible than others. Changing asset allocations is usually easy because one investment can be exchanged for another with no tax consequences. A final advantage is that lower-income taxpayers can now get a credit on their taxes for a portion of their annual contribution. That means that they not only exclude their contribution from their taxable income, but they reduce the amount of tax paid on the rest of their income. Most investors should consider it a high priority to contribute to tax-sheltered plans.
The Roth IRA is also a tax shelter, but it works differently from a traditional IRA or any retirement plan that is funded with pre-tax dollars. In the traditional IRA, you don't have to pay taxes on the money you put into the account, but you do have to pay taxes on everything you take out. The Roth IRA works in reverse: You do have to pay taxes on the earnings you put in, but you don't have to pay taxes on what you take out. To decide which is better, the cost of present taxes (Roth) must be weighed against the potential cost of future taxes (traditional). The Roth IRA is a good deal for young workers in very low tax brackets, who by paying a little in taxes now can create a growing account that will never be taxed again. For workers in higher brackets, the deductibility of a traditional IRA contribution is a significant advantage. Since the deduction comes "off the top" of their income, they save taxes now at the highest rate that they pay. On the other hand, if someday their IRA withdrawals constitute a large portion of their income, only the portion that exceeds a certain bracket threshold may be taxed at the highest rate they pay. That subtle distinction may tilt the decision in favor of the traditional IRA for middle- to higher-income workers, assuming that the IRA is fully deductible (see below).
Less advantageous shelters
Not all tax shelters are appropriate for all investors. Some tax shelters do shelter earnings on investment returns until withdrawal, but offer neither the advantage of tax-deductible contributions, nor the advantage of tax-free withdrawals. An example is the deferred variable annuity offered by insurance companies. If you invest in it outside of an employer-sponsored retirement plan, you have to fund it with after-tax dollars. You don't get to exclude your contributions from your taxable income, as you would in a 401(k) or traditional IRA. And when you take money out, you will have to pay taxes on the earnings at ordinary income tax rates, not the lower dividends or capital gains rates. In addition, many annuities have very high costs (see section 6).
A traditional (non-Roth) IRA is not as advantageous for high-income taxpayers who are covered by retirement plans through their employer, because their IRA contribution may be partly or wholly non-deductible. Also, if you mix deductible and non-deductible contributions within the same IRA, the calculation of tax liability when withdrawals begin will be more complicated.
Minimizing taxes in taxable accounts
Federal taxes on dividends and capital gains have been reduced to 15% for most taxpayers. This reduces the value of tax shelters for stock investments, especially if contributions to the sheltered account are not tax deductible. There are other ways to avoid current taxes on stock returns besides tax shelters anyway. If you don't need any income from the stock right now, you can avoid dividend taxes by investing in companies that retain their earnings rather than paying them out in dividends (or in mutual funds whose stated objective is growth rather than income). Your return will then be entirely in the form of capital gains when you sell.
You can also put off capital gains taxes for a long time by buying and holding stocks rather than selling them frequently. People who trade frequently have to pay taxes immediately on any capital gains they realize. Frequent trading is also a problem for many mutual funds, especially actively managed funds that are trying to beat the market. They can generate a lot of capital gains that you have to pay taxes on, even if you don't need the income. Index funds are more tax-efficient because they have lower turnover. They don't generate very much taxable income until you decide to sell your shares. Some mutual funds are deliberately "tax-managed" funds that try to avoid generating any taxable income, by avoiding both turnover and dividend-paying stocks. Ideally you don't pay any taxes at all until you sell.
By now we have a long list of advantages of investing in index funds: They provide automatic diversification because they buy every stock in the index, lower risk because they always give you close to a market return, lower fees and expenses because they don't have to do much research or trading, and high tax efficiency because of low turnover.
Prioritizing investment options
With so many kinds of tax breaks to choose from, how should investors distribute their investment dollars, especially when saving for retirement? For most employees, the first priority should be to contribute enough to their employer-sponsored retirement plan to take advantage of any matching funds contributed by the employer. If you are currently in a low tax bracket, the next priority would be to contribute the maximum allowed to a Roth IRA. Then make additional contributions to your employer-sponsored plan, traditional IRA (if you're not contributing to a Roth), or educational savings plan. If you are fortunate enough to have more money to invest than you are willing and able to shelter from taxes, put it into investments that either generate little taxable income or that take advantage of the low tax rates on dividends and capital gains.
Dividing investments between taxable and sheltered accounts
If you have both tax-sheltered investments and taxable investments, which investments to put in which category can be tricky. This is sometimes called the asset location question as opposed to the asset allocation question. One consideration is time horizon. If your taxable investments are short-term investments, then they should be conservatively invested in cash and bonds rather than stock. In that case, hold your stock in your tax-sheltered retirement account, where it has time to ride out the ups and downs of the market.
But if you also have long-term taxable investments, you have more options. Now you need to decide which of your long-term investments belong in your tax shelter, and which belong in your taxable account. The investments that benefit the most from tax sheltering are those with both a high return and a potential to generate current taxable income. Stocks that pay dividends and actively managed mutual funds realizing a lot of capital gains would be in this category. Investments that benefit the least from tax sheltering are stocks that are held for appreciation rather than dividends, or tax-efficient index funds that rarely realize capital gains by selling shares. They generate little taxable income now, and when you realize your gains in retirement they will be taxed at low capital gains rates. But if they are held in a tax shelter, the gains will eventually be taxed at ordinary income rates when you make withdrawals. You get a tax break when you put money in, but forfeit a tax break when you take money out.
That doesn't mean that index funds never belong in tax shelters. It makes sense to set up a retirement plan where you can invest with pre-tax dollars, and it also makes sense to own index funds for their diversification, low risk and low expenses. If your retirement plan is all you have in long-term savings, then that's where your index funds will be. But if you have a choice, keep your most tax-efficient investments in your taxable account and less tax-efficient investments in your tax shelter. This distinction is most important for investments with a high long-term return, such as stock, real estate and commodities. The stakes are not as high for bonds, although bonds with higher yields do benefit from tax sheltering more than bonds with lower yields. Treasury bonds benefit a little less from sheltering than corporate bonds, since treasuries are already exempt from state taxes. Municipal bonds are not appropriate for tax shelters at all, since they are exempt from federal taxes.
The Roth IRA is a special situation because you've already paid your taxes before you put the money in, and the earnings will never be taxed at any rate. So you may want to invest a Roth in whatever you expect to give you the highest long-run total return, consistent with your tolerance for risk. That could be something like a small-cap stock fund.