In November 1789, Benjamin Franklin lamented in a letter to a friend that there are only two certainties in life: death and taxes. Sure enough, Franklin died less than six months later, after paying a hefty share in taxes to the newly established republic he had helped found.
While taxes are a staple of modern life, Congress will occasionally adopt relief measures to help ease the tax burden and encourage certain behaviors. One of these laws, the Taxpayer Relief Act of 1997, introduced the Roth IRA, a tax-efficient savings vehicle that middle-class Americans could use to prepare for retirement.
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The largest savings account in America?
Unlike a traditional individual retirement account (IRA) where savers contributed in pre-tax dollars, had access to tax-deferred growth, and then were taxed on withdrawals at retirement, taxpayers saving in a Roth IRA would contribute up front. in after-tax dollars. In exchange, the Roth funds would be permanently sheltered from federal income tax – allowing savers to enjoy both tax-free growth and tax-free withdrawals.
This extraordinary quirk makes the Roth IRA a great place to house what would otherwise be tax inefficient investments, since interest, rent, capital gains, and dividend income earned from Roth holdings are not taxed. Below are some important assets to have in a Roth IRA.
Dividends paid by publicly traded companies are already tax-efficient, as eligible dividends are subject to lower long-term capital gains tax rates – a maximum of 23.8%, including the income surtax. net investment of 3.8%.
However, this is far from 0%, and it weighs on the performance of investors who reinvest their dividends to improve portfolio returns. If you instead choose to hold dividend-paying stocks in a Roth IRA, you can opt out – participate in a dividend reinvestment program – without having to pay Uncle Sam first.
Real Estate Investment Trust (REIT)
Since REITs are required by law to distribute at least 90% of their annual income to shareholders, many of them feature high returns and are attractive to investors seeking consistent portfolio income. Unfortunately, REIT distributions are generally taxed as ordinary income, which may be subject to rates of up to 40.8%, after including the 3.8% surtax.
On the other hand, if you buy REITs with the money already in your Roth IRA, you can spend or reinvest that income without owing a dime in tax.
High turnover fund
If you’ve ever held mutual funds or ETFs in a taxable account, you may have noticed that you owe capital gains tax even though you didn’t personally sell your shares – this is because you are also taxed on sales made by the funds.
High turnover funds (those that frequently buy, sell and replace their holdings) are less tax efficient than buy and hold funds which rarely sell or rebalance their investments. Indeed, each sale on the funds This level has a tax consequence which is often passed on to individual shareholders. And the higher the fund’s turnover rate, the more likely you are to be affected by these taxes, which can seriously eat into your returns.
Of course, when you have high yielding mutual funds in your Roth IRA, you won’t have to worry about taxes at all, whether you or the fund made the sale. Register your taxable brokerage account for low turnover, tax-optimized funds like Vanguard’s Total Stock Market Index Fund, Admiral Shares (NASDAQMUTFUND: VTSAX) rather.
The tax code is generous to investors, subjecting most capital income to long-term capital gains tax rates, but only if you hold an investment for a year or more. Anything you sell at a profit with a holding period of less than a year will trigger much less favorable short-term capital gains taxes, which are equivalent to regular income rates.
Fortunately, you can use this fact to your advantage by buying investments that you plan to sell within a year in your Roth IRA – and avoiding income taxes altogether. In the meantime, it is a good idea to allocate the part of your portfolio held in taxable accounts to long-term holdings, so that your wealth can be invested in a fiscally optimal manner.
A good investment is not just about getting a high rate of return. It’s also about optimizing your portfolio so that you can dungeon as much of what you earn as possible, making a thoughtful tax strategy an important part of any sound investment policy. Using a Roth IRA to hold investments with otherwise high tax burdens is a great way to start – and can pay off in earnest.
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