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3 Ways You Can Beat Higher Taxes

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When you're trying to save enough to retire rich, taxes are your enemy. Yet as the saying goes, sometimes it makes sense to keep your enemies close to you.

Given unprecedented budget deficits and the possibility of new, costly government programs on the horizon, pretty much everyone now expects income tax rates to go up in the future. In order to beat higher taxes before they get you, you may actually need to consider something you would normally never even think about: paying taxes sooner rather than later.

When deferral doesn't work
Ordinarily, it's smart to put off paying taxes as long as possible. After all, every dollar you pay in taxes is a dollar that you can't invest. Paying taxes earlier than you have to costs you not only that dollar, but also all the income and capital gains that it would have generated for you. Conversely, by deferring tax, you're the one who earns a return on that money, not the IRS.

The situation changes, though, when you know that tax rates are going to increase in the near future. Obviously, there's a powerful incentive to pay $1 in tax today if by doing so, you avoid having to pay $2 in tax tomorrow.

That's why you should take a close look at three different strategies designed to make the most of today's lower tax rates while they last.

1. Take your gains.
One of the best things about investing in stocks is that you don't have to pay tax on your capital gains until you sell. If you're a buy-and-hold investor, therefore, you have complete control over your tax liability. With today's 15% maximum capital gains rate in danger of rising to 20% or more, it might be better for you to sell now and pay tax at a lower rate than to hold on and have to pay more in taxes later.

For instance, say you have a big gain on a stock you've held for a long time. You anticipate you'll need to sell 1,000 shares within the next few years to cover your living expenses. Take a look at how much you might save by selling now versus waiting until a higher tax takes effect:

Stock

Year Bought

Tax If Sold Now

Tax If Sold When 20% Rate Applies

Microsoft (Nasdaq: MSFT  )

1989

$3,677

$4,902

Google (Nasdaq: GOOG  )

2004

$54,696

$72,928

PotashCorp (NYSE: POT  )

1999

$12,288

$16,384

Coca-Cola (NYSE: KO  )

1989

$6,909

$9,212

United Technologies (NYSE: UTX  )

1994

$8,387

$11,182

Source: Yahoo! Finance. Assumes dividends held in non-taxable account.

If you're concerned that you don't want to miss out on potential gains between now and when you need the money, you can buy back your shares immediately after you sell them. Although that strategy doesn't work with tax losses, there's no wash-sale rule on gains.

2. Use Roth IRAs rather than traditional ones.
Many people prefer traditional IRAs over Roth IRAs because traditional IRAs give you a current tax deduction. The tradeoff, though, is that with a traditional IRA, you have to pay taxes when you withdraw money from your account in retirement.

Higher taxes in the future may be enough to shift the balance in favor of a Roth. By giving up your deduction, you'll pay more tax now -- but in exchange, you'll avoid getting taxed at a higher rate later. That's especially useful if you plan to retire in the near future.

3. Shift dividend stocks to tax-favored accounts.
Until 2003, dividend income was taxed at the same higher rate as most other income, including your salary. But a tax law change gave dividends the same 15% tax rate that applies to capital gains. That made it cheaper to hold high-dividend stocks like BP (NYSE: BP  ) and AT&T (NYSE: T  ) in a taxable account.

A prospective tax increase could well remove or at least increase that preferential rate on dividends. In that case, adjusting your portfolio to put your dividend-paying stocks into an IRA rather than your taxable account could save you from immediately having to fork over up to 35% or more of those payouts to the IRS.

You'll have time
You don't have to worry about making these moves right now. In the past, most tax law changes have been applied prospectively, meaning that you'll have fair warning to plan accordingly for whatever changes occur. Yet by preparing for the future now, you can avoid having to rush when the time comes. The thousands you could save on your taxes makes it well worth the trouble.

If you think Social Security is a Ponzi scheme that will bite tomorrow's retirees, you're not alone. Chuck Saletta explains why you should provide for your own retirement and how our Rule Your Retirement newsletter can help.

Fool contributor Dan Caplinger pays attention to taxes like a hawk. He doesn't own shares of the companies mentioned in this article. Google is a Motley Fool Rule Breakers pick. Coca-Cola and Microsoft are Inside Value picks. Coca-Cola is an Income Investor selection. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is always prepared.


Read/Post Comments (26) | Recommend This Article (50)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 14, 2009, at 4:52 PM, plange01 wrote:

    under the current market conditions you can pretty much forget about buy and hold at least for now.you will lose or go nowhere.for now you need to be more active trade more often.this brings in more money by far and more taxes with it.get used to recieving frequent letters from the irs asking for more! i have gone from quartly payments to 6 or more a year...

  • Report this Comment On September 14, 2009, at 5:16 PM, polarweasel wrote:

    I enjoy spare money in my pocket just as much as the next guy, but this unending quest to maximize personal gains at the expense of everyone else is a fool's errand that is doing great damage to the fabric of our society. How about people try out a new strategy? Pay the tax that you owe fair and square, not a penny more—but not a penny LESS, either.

  • Report this Comment On September 14, 2009, at 5:30 PM, matthewbanis wrote:

    polarweasel,

    feel free to give away your money to an inefficient government and slackers who don't work.

    don't think about touching my money.

    this country is based on capitalism, not socialism.

    thanks.

  • Report this Comment On September 14, 2009, at 5:52 PM, CPAdallas wrote:

    Putting dividends into a regular IRA does NOT save taxes, since the IRA distributions that you'll eventually take will always be taxed at ordinary income rates. Ditto capital gains that accumulate in regular IRAs: taxed on distribution at ordinary rates.

  • Report this Comment On September 14, 2009, at 6:14 PM, eddietheinvestor wrote:

    Thanks, Dan, for your fine post about saving on taxes. But your post assumes that taxes will go up, yet there is no proof of that. President Obama has promised on many occasions not to raise taxes on anyone making less than $250,000 a year. Raising taxes on capital gains and on dividends would be a tax on people of all income levels, including middle-class families, which would contradict Obama's pledge not to raise taxes on people making less than 250,000.

  • Report this Comment On September 14, 2009, at 6:55 PM, peters46 wrote:

    And he has already raised taxes on smokers (most of whom have incomes way lower than 250k). Or are you a normal dem who believes all smokers are evil and stupid and so don't count as people. He WILL raise taxes.

  • Report this Comment On September 14, 2009, at 7:00 PM, menefer wrote:

    Author suggests making changes to your portfolio based on tax increases that no one has proposed and then exagerates them. Move my dividend stocks to my IRA to avoid 35% tax rate? First, how many are in the 35% bracket? Then who has suggested doing away with a lower tax rate for dividends? Maybe they are talking it about it on FOX to scare the uninformed, but not in the real world. Only change I've even heard discussed, is to change 15% on LTG and dividends to 20% for those earning over $250K. This article gives bad advice that could cost you plenty in taxes at 15% to avoid something that isn't going to happen. Shame on you Dan!

  • Report this Comment On September 14, 2009, at 7:22 PM, jrj90620 wrote:

    Is California the only state with a capital gains tax?Everywhere, I read articles about a 15% max long term capital gains tax but I think there is an alternative minimum tax and also a 10% tax in California.How do all you guys in every other state get away with only a 15% total tax on capital gains?I thought there were only a handfull of states without a cap gains tax and many get hit with the alternative min tax.

  • Report this Comment On September 14, 2009, at 8:10 PM, stockmenot wrote:

    Peters46: Unfortunately I do believe that smokers lack intelligence, because anyone alive today knows how dangerous it is, and to engage in it is suicide and an irresponsible burden to the rest of us to pick up your hospital(s) bills. Tax them to death.

    Esterlin: You are either very young, or very naive to believe that any politician will keep his word.

    Not only will he raise taxes on all of us,(Thanks to Bush) but in the indirect ways, such as Stocks. The fine print is "salary." Don't expect that to include your investments, or any of the goodies you go out and buy where they can stick it to you.

    You must have a lot of kitty's.

  • Report this Comment On September 14, 2009, at 8:39 PM, xetn wrote:

    A better strategy is to lobby your congressman/senator and demand a cut in federal spending with a corresponding cut in taxes, on penalty of being removed from office for not doing so.

    Just to make it clear, taxes are theft at the point of a gun. And the biggest tax of all is the hidden tax of monetary inflation as a result of the FED creating money out of thin air. The long-term result is loss of purchasing power (the hidden tax).

    Since 1913 when the Fed and the income tax were created, the dollar has lost over 95% of its value.

  • Report this Comment On September 14, 2009, at 9:01 PM, AirForceFool wrote:

    While I certainly agree with the gist of the article, I'm not quite ready to convert over my accounts... I'll just be uber-ready when the time comes. :P

    I don't have a problem paing a fair share in taxes, the problem is who gets to decide what's fair... taxfoundation.org quotes the percentage of Americans payin zero, or less than zero taxes (thanks EIC...sigh...)...

    I recommend a consumption tax. Tax folks whenevery they buy something... if people want to save money... fine... no taxes... worse case scenario their kids will spend it (and get taxed) after they pass away... if you want to go all soft, you could exempt each household an amount equal to the poverty level for that size household... that way a family of four making less than say $28K (or whatever number was acceptable)... they'd end up with a refund for that amount... say 20% of $28K.

    If you're Bill Gates, and you buy a million dollar whosit, then bam... 200K is tax (assuming a 20% tax rate).

    As far as new taxes go... I figure we either have to pay more in taxes or stop spending like we are. I vote for government to ummmm.... spend a little less... like Social Security for crying out loud... did you Fools know that if you're collecting Social Security, and you're raising your grandchild you actually collect for them as well? I'm not arguing about the merits of helping grandparents raise their pot smoking children's children, just that you shouldn't collect Social Security if you've NEVER worked.

    Plange01: hit the nail on the head... buy and hold worked before, and may be good for those who have a ten plus year timeframe, but the market is going to flucuate... I use options to ensure a certain price and take advantage of market volatility.

  • Report this Comment On September 15, 2009, at 12:52 AM, Trime2x1 wrote:

    To Esterlin,

    The CBO has analyzed the proposed admin budget and project that by 2019 the national debt will be $17 trillion, or 82% of GDP, and interest paid on this debt will consume 20% of federal revenues...I believe your taxes will go up and up, and up!

    Take advantage of the new rule for Roth IRAs in 2010.

    You'll be able to convert your IRA to Roth IRA because the taxpayer income limit will be lifted. So pay the taxes over the next two years and not worry about it later. I would also look at life insurance as well, another great vehicle to protect yourself from taxes.

  • Report this Comment On September 15, 2009, at 2:40 AM, PoundMutt wrote:

    Trime2x1 wrote:

    "The CBO has analyzed the proposed admin budget and project that by 2019 the national debt will be $17 trillion, or 82% of GDP, and interest paid on this debt will consume 20% of federal revenues...Take advantage of the new rule for Roth IRAs in 2010....also look at life insurance as well,..."

    With the coming desperation of the gov't for tax revenue, how long do you think ROTH IRAs and Life Insurance will remain untaxed?

  • Report this Comment On September 15, 2009, at 7:21 AM, Windsurfing1 wrote:

    Or you can move to a country which does not know capital gains tax. You might have to give up your original passport, worst case or arrange a settlement with the IRS. I live in a country which gave up on capital gains tax in 1985 and it makes investing less complicated. But if you want to keep your original passport, definitively speak to your local tax authorities (US= IRS) first. Mostly you can make a deal, since they have the option of loosing all income or only part of it.

  • Report this Comment On September 15, 2009, at 9:39 AM, catoismymotor wrote:

    No proof taxes are going up? Are you serious? A socialist is sitting in the big chair. He will tax the hair on your head if it means he can use the money to buy the votes of the mindless entitlement program leaches that worked so hard to put him there to begin with. This guy makes Jimmy Carter look like a moderate.

  • Report this Comment On September 15, 2009, at 9:41 AM, catoismymotor wrote:

    Leaches = Leeches

    When I become empassioned the fingers fly without regard to spelling accuracy. I have spoken to them about this, yet they ignore me. Fool on! :)

  • Report this Comment On September 15, 2009, at 9:46 AM, jfenlon wrote:

    Politicians will not stop spending. Their reelection depends on it. Here's something else to consider. The number of children per muslim family exceeds eight. The number per caucasian is dropping, close to two. Only the high birth rate among hispanics in the USA is keeeping the non-muslim to muslim ratio from tilting heavily in favor of muslims. There is no hispanic birth rate in France, Great Britain, or Germany. Each of those countries has a caucasian birth rate less than two per family. All will have a muslim majority after 2030. Khadaffi noted this in a speech.

  • Report this Comment On September 15, 2009, at 10:07 AM, catoismymotor wrote:

    jfenlon,

    So I conclude that we need to deport the majority of our illegal immigrants to Europe to balance the scales. I'm down with that.

    Cato.

  • Report this Comment On September 15, 2009, at 1:06 PM, msm3rd wrote:

    I have always been curious about the tax debate. It seems that taxes are a way to give us a civilized society rather than a "dog eat dog" society. How many of us would rather plow our own streets in winter, fix our own potholes, requisition our own military personnel, go back to volunteer fire departments, have no government help in floods, fires, hurricanes, tornadoes - you get my drift.

    Taxes are not evil in and of themselves, and as a society we certainly disagree on how best to spend the money. Some of us would rather spend more on schools, some would rather spend more on the military. I think the problem lies in the disagreement on how much money we should spend on what. If we favored the war in Iraq, we should be willing to spend more in taxes because more money is required. If we did not, could we have said no to that portion of our tax bill? I think not. What we need is to have everyone pay their fair share and not continue to create loopholes so that only the wealthy are able to figure out how to pay less than their share.

  • Report this Comment On September 15, 2009, at 2:29 PM, LesWood1 wrote:

    Let's see, there are those who want to tax smokers because it's a dirty habit. There are those who want to tax obese people because they look fat, lazy and apparently eat too much.

    Being as we are in a taxing mood, I say that we heavily tax drunk drivers and those who drive while under the influence of other drugs. When I say heavily, I say a minimum of $10,000 for the first incident and double thereafter.

    I say that we tax those who have AIDS the heaviest of all. We have all been taxed upwards of twenty billion dollars or more for medical coverage and research to cure a disease brought on by those who partake in a filthty lifestyle of perferted sex and sharing needles in drug use.

    I say that we tax lobbiests who have cost us trillions of dollars in pork projects at least 95% of what they pay in bribes to our elected officials.

    I say that we tax our elected officials by making them a retirement package that is equal to social security, and medical coverage through Medicare and Medicaid.

    I could go on, but I hope that you people who want to tax, tax, tax, should get the point.

    What we really need is to reduce taxes and encourage new businesses to hire millions of employees. The taxes generated through trickle down economics has always worked to create prosperity and freedom.

  • Report this Comment On September 15, 2009, at 5:35 PM, menefer wrote:

    I always love when right wingers say "reduce taxes and encourage new businesses to hire millions of employees." Exactly what new business would you start if we cut your taxes? When no one is starting a new business or hiring new employees, a tax cut won't help. What you need is exactly what we are doing and that is why the government has increased spending. When you build a new bridge, pave a highway, develop an electric car, build a wind farm, now you have private business taking on these jobs and hiring people to do them. The good news is that the people running our country realize this and the "tax cut" people have been sent home.

  • Report this Comment On September 15, 2009, at 8:05 PM, done4nau wrote:

    Don't blame Obama for any tax problems. He didn't cause the problems. The Wall Street geniuses who don't follow the rules of basic economics and good stewardship caused the mess. I, for one, would like a payback of all the money they lost me in 2000 and in 2008. I don't much like going from plenty to poverty while they went from have much to have it all.

    Only the people who were part of the rip off have anything left to tax. May they lose their shirts.

  • Report this Comment On September 15, 2009, at 8:44 PM, mtracy9 wrote:

    Obama will have to raise taxes on people making more than $250,000 per year to make up for the reckless military spending and tax cuts during the Bush regime, which during its 8 years in office doubled the national debt from $5 trillion to $10 trillion.

  • Report this Comment On September 16, 2009, at 12:08 AM, freelivin91 wrote:

    There are, in addition to Roth IRA's, IRA's, and other retirement vehicles, several life insurance vehicles that allow you to invest in the market on a tax deferred basis, and then take the money out later tax free. Just has to be structured properly.

  • Report this Comment On September 16, 2009, at 1:03 PM, Investable1876 wrote:

    After the past year of massive turmoil in the economy and the markets, investors are wondering where they can invest that is relatively safe and smart and provide a higher return than cash. Tax-free municipal bonds can provide some stability and a reasonable after-tax return for many investor portfolios. It is a virtual certainty that income tax rates will be going up (especially for the "rich") over the next few years to pay for all the huge government borrowing and spending that is going on right now. Social security and Medicare also need increased "funding" from tax revenues. Increasing income tax rates make tax-free municipal bonds more attractive relative to other investments. Historically Muni's have performed well during periods of rising tax rates. Municipal bonds appear attractive relative to US treasury bonds and cash right now because they offer higher yields, lower taxes, and only slightly higher risk (depending on the state) in my opinion.

    -----------------------------

    Money is like muck, not good except it be spread.

    http://www.topinvestingtips.com

  • Report this Comment On September 16, 2009, at 4:18 PM, ragie wrote:

    There will always be taxes on income, gains etc.- no getting around that. Once this country started income taxes, it could not stop and it is a little out of control now. I do not mind paying taxes as long as our govt uses it wisely, which can be subjective. lol.

    On a somber note: I've found 6 new taxes (2 are deductions taken away) in the healthcare reform bill and I'm only about 500 pages into it (you should read it if you do not believe me). Scary stuff for someone like me who is disabled (no $$ from social security even though I paid in for 20 years) and is also 20 years away from retirement and has a young child to think of. I lost a lot last year in my old 401-k because I did not take control of my investments. A lesson well learned as I lost over 60% and never could get that back because they sold everything. Oh well.

    However - this is my understanding of taxes & IRA;s Roths and capital gains.

    Capital gains are at 15% right now and will expire next year and return to the 25% - 35% depending on how long you've owned the stock. It makes some sense to sell and pay now rather than 35% later.

    Note that on Roth IRA's (if you rollover from a regular IRA) then you pay tax on it now, but when you withdraw it you do not pay tax on the "original" amount you put in and also additional after tax payments made into it That's important to remember.

    Withdrawels that are over the amounts put into it (the growth, dividends etc) will be taxed at whatever rate you are in when you withdraw it. It does grow tax deferred but they do tax the gains on it, so be clear on that before you make decisions based strictly on tax implications. Hope that you pay less tax when you withdraw it, but I do not see how that can happen unless you are unemployed for 2 years prior to retirement. I look back over the last 20 years and have increasingly paid more taxes, never less.

    Roth IRA's also do not have a strict age requrement like regular IRA's and a minimum distribution percentage to take every year, so it is a good play for anyone, I think. You can start withdrawing as early as 59 1/2 on Roths.

    Also keep in mind that in 2010 and 2011 tax years (if you rollover in 2010 from a regular IRA to Roth IRA) you can spread the tax burden over 2 years but it must be done rolled over in 2010. If you do it in 2009 you pay in full for 2009 tax on it. I hope they do not reverse that deduction as it is open for removing so watch for that it could change.

    Happy investing!

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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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