Hunting for investment winners is fun. Managing taxes is tedious. Yet a few hours each year devoted to minimizing your portfolio’s tax bill will likely yield a far bigger financial return.
Imagine you invest $10,000 for 30 years and earn 8% a year. If you lost 25% of your gain to taxes every year, you would have $57,435 after 30 years, which sounds impressive. Now, instead, suppose you could defer all taxes for 30 years, at which point you got dinged at 25% on your 30 years of tax-deferred growth. Result: You would walk away with $77,970, or 36% more.
There are two golden rules when managing taxes. First, it’s usually better to pay taxes later. If you have a choice between paying taxes this year and paying in 10 years, you should take the second option. During the extra 10 years that you hang onto money earmarked for Uncle Sam, you can use that money to earn additional gains for yourself. This tax deferral is one of the compelling advantages offered by retirement accounts. It’s also the reason people will realize investment losses and bulk up on tax deductions during the current tax year, while putting off income and capital gains until later.
Second, when you pay taxes, you want to pay at the lowest rate possible. That means favoring investments that are taxed less onerously. This should be a key factor when investing your taxable account. But it also means seizing the opportunity offered by years when you have little taxable income, which may include your early retirement years or a year when you’re out of work. Indeed, while paying taxes later is rule No. 1, sometimes rule No. 2 means breaking rule No. 1.
Ready to get started? This chapter begins with an overview of the federal tax code and then explores three strategies for managing your investment tax bill.
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