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These Stocks Will Help You Beat the IRS

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Making money in today's volatile financial markets is already challenging enough without having to worry about taxes. Yet if you're not careful, you could lose a big portion of whatever profits you do scrape together to the IRS.

Fortunately, investors do have a number of options that let them invest without having to deal with an immediate tax impact. By using IRAs and 401(k) retirement plans, you can save for retirement with distinct tax advantages, including not having to pay tax on any income from interest, dividends, or capital gains for as long as you keep your money in the retirement account. 529 savings plans fulfill the same purpose for those putting money aside for college, and a few other products, such as annuities, also give investors the opportunity for tax-deferred growth.

But once you've allocated as much as you can afford to tax-favored investments, you'll probably have some money that you want to keep accessible. Given that the investments you make will be fully taxable, what's the best way to minimize your tax bill every year?

Picking the right stocks
Tax-favored accounts give you a lot of latitude. You can invest in pretty much whatever you want, without worrying about the tax consequences of frequent transactions or receiving income.

When you invest in your regular taxable account, considerations like the following become much more important:

  • Every interest or dividend payment you receive may be taxable, and different tax rates may apply depending on what type of investment it is.
  • Every time you trade, you may have a capital gain that incurs tax. If you've owned an investment for a year or less, then the rate that may apply could be a lot higher than if you've held the investment for longer than a year.
  • On the other hand, as long as you hold onto a stock, you don't have to pay tax on the paper gains you have. Only once you sell do those gains become taxable.

So to minimize taxes, you'd ideally like to pick stocks that you can buy and hold for a long time, saving ones you intend to trade more frequently for tax-favored accounts. Dividend-paying stocks may generally be smart, but if you want less taxable income, ideally you'd like stocks that don't pay dividends, but will still have strong price appreciation. Over the past five years, these stocks have been good examples:

Stock

5-Year Avg Annual Return

Intuitive Surgical (Nasdaq: ISRG  )

57.6%

Titanium Metals (NYSE: TIE  )

25.3%

Nasdaq OMX Group (Nasdaq: NDAQ  )

21.4%

McAfee (NYSE: MFE  )

16.2%

Red Hat (NYSE: RHT  )

16.0%

Google (Nasdaq: GOOG  )

30.3%

Amazon.com (Nasdaq: AMZN  )

18.6%

Source: Yahoo! Finance.

Of course, it's not that easy to try to figure out which stocks will give you the best returns over the next five years. But stocks that produce no income will help you defer tax as long as possible, even in a taxable account. That'll leave your tax-favored accounts to shelter income-producing securities.

What to avoid
In contrast, certain types of investments carry a heavy burden in taxable accounts. They include:

  • TIPS. Inflation-indexed bonds serve a valuable purpose, but when it comes to taxes, they can be painful. TIPS owners are taxed on the inflation adjustment to their bonds every year, even though they don't actually receive any cash until the bond matures. That's a form of phantom income that creates tax without putting any money in your pocket.
  • Collectibles. Investing in items like gold and silver bullion has gotten much more popular lately, with the run-up in precious metals prices. But in taxable accounts, the gains from collectibles are taxed at a special maximum 28% rate, well above the 15% that currently applies on long-term gains from most other investments.
  • REITs. Real estate investment trusts typically don't qualify for the lower tax rate on dividend stocks. That means you could pay as much as 35% on REIT income.

Find the right place
Taking maximum advantage of tax-favored accounts is smart. But even with money you have in regular taxable accounts, you can still take steps to minimize your tax burden. Right now, cutting your tax bill is the best way to keep more money for yourself.

For more on how to balance your taxable and tax-favored accounts, take a look at the Fool's Rule Your Retirement newsletter. You can spend the next 30 days looking through all the resources Rule Your Retirement offers its subscribers with a free, no-obligation trial -- just click here to start today.

Fool contributor Dan Caplinger has most of his investments in the right place. He doesn't own shares of the companies mentioned in this article. Google and Intuitive Surgical are Motley Fool Rule Breakers recommendations. Amazon.com and Titanium Metals are Stock Advisor selections. The Fool has written puts on Nasdaq OMX Group, which is an Inside Value pick. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy won't cost you a dime in taxes.


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Dan Caplinger
TMFGalagan

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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