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Why Pay Taxes When You Don't Have to?

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Wondering where you should park your investments? That's a good thing to ponder, because you can save yourself a lot of money by employing a little strategy. Be careful, though, because not all the advice out there will serve you best.

For example, below are some typical rules of thumb on the best places for certain types of investments. Know that a taxable account would be something like your regular brokerage account. Your traditional IRA or 401(k) plan is a tax-deferred account. And a Roth IRA is a tax-free one.

  • Most income-producing investments, like money-market funds, CDs, real estate investment trusts (REITs), and bond funds, do best in a tax-deferred or tax-free account. But municipal bonds and funds should go in your taxable account.
  • If you plan to own stock for a year or less, it fits better in a tax-deferred or tax-free account. But long-term holdings for more than a year work well in a taxable account.
  • Stock mutual funds tend to do well in a taxable account. However, those that have high turnover should go into a tax-free or tax-deferred account.

Here's the logic behind these rules:

  • With investments that kick out income that gets taxed at your ordinary income rate (think of interest, short-term capital gains, and REIT dividends), you might want to pay no taxes on them, or have the taxation deferred until later, when you may be in a lower tax bracket (such as during retirement).
  • With investments that kick out tax-free income, such as municipal bonds, you might as well hold them in a taxable account -- the tax-advantaged accounts don't help you at all.
  • With investments that kick out income that's taxed at a relatively low rate (such as the qualifying dividends from most dividend-paying stocks and stock funds), you can hold them in a taxable account.
  • With low-turnover investments, capital gains are likely to be long-term ones, and therefore will automatically enjoy a lower tax rate. So a taxable account is less problematic than with a high-turnover fund.

But hold on ...
Making the best decision isn't always as simple as following these rules of thumb, though. For example, are taxable accounts really the best places for long-term stock holdings and dividend-paying stocks? It's true that they have favorable tax rates now, but will they last? Many see tax rates rising in the near future.

Next, even if these investments are being taxed at a lower rate, they can be such powerful growers that even a low tax rate can result in a substantial hit. Check out the following, for example:

Company

CAPS Stars (out of 5)

20-Year Avg. Annual Return

$10,000 Invested 20 Years Ago Becomes

15% Tax on Gain

Cisco Systems (Nasdaq: CSCO  )

****

33%^

$2.4 million^

$358,000

Best Buy (NYSE: BBY  )

**

29%

$1.62 million

$241,000

Altria (NYSE: MO  )

****

14%

$137,000

$19,000

Caterpillar (NYSE: CAT  )

****

14%

$125,000

$17,300

Procter & Gamble (NYSE: PG  )

*****

13%

$108,000

$14,600

IBM (NYSE: IBM  )

***

10%

$65,900

$8,400

General Electric (NYSE: GE  )

****

9%

$56,000

$6,900

Data: Yahoo! Finance, Motley Fool CAPS. ^Over past 19 years.

The table above shows just how much you'd be forking over to Uncle Sam, even when you're paying a "low" 15% tax rate. Now, 15% actually is low, historically speaking, and we should enjoy it and make the most of it while we have it. But if you have the chance to park any long-term stocks or dividend-paying stocks in your Roth IRA, I think you should seriously consider doing so. Clearly, you'd save a lot of money. (And yes, some of your holdings won't turn in blockbuster returns, but very often those that do far outshadow the laggards.)

Another important thing to notice in the table above is what good growth you can get from common, well-known names. Sure, 20 years ago, not everyone knew about Cisco Systems, and it wasn't clear that it would become a powerhouse, offering some of the best returns available. But almost everyone did know about Procter & Gamble and Caterpillar, and their growth rates were more than double that of the overall market.

So take advantage of the miracle of dividends -- especially now that so many stocks are on sale. And park them in the account that makes the most sense for you. If you really need to minimize your current taxes, a traditional IRA can do the trick for you (or mutual funds in a 401(k)). But if you're looking for long-term growth, a Roth IRA might be your best bet.

If you're interested in Roth IRAs, you won't want to miss this. Read all about the rare opportunity that's coming up that will open the doors to a Roth for many investors.

Longtime Fool contributor Selena Maranjian owns shares of Procter & Gamble and General Electric. Best Buy is a Motley Fool Stock Advisor recommendation and a Motley Fool Inside Value selection. Procter & Gamble is a Motley Fool Income Investor pick. The Fool owns shares of Procter & Gamble and Best Buy. Try any of our investing newsletters free for 30 days. The Motley Fool is Fools writing for Fools.


Read/Post Comments (2) | Recommend This Article (2)

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 October 22, 2009, at 9:03 PM, wjcoffman wrote:

    Just to be clear, at least to me, when you write "park" you mean buy those investments in a tax-free (such as Roth IRA) account right? You don't mean that if you own these investments to move them to the tax-free account as my understanding is you can only add cash or "rollover" holdings to a tax-free account.

  • Report this Comment On October 28, 2009, at 6:01 AM, SebastianZ wrote:

    To many people the term tax rebate connotes the happy idea of a government sending back some amount of taxes already paid, which may occur or be recommended by governments during lean economic times, or when taxes are over-collected. There is a lot of interest in what people do with tax rebates – but no one seems interested what people do with payday loans, if they use them. A study by University of Chicago faculty from 2008 found that payday lending declined in people that use payday loans towards bills and assistance declines around the period of tax rebates, but lending to those that used payday loans for discretionary uses didn't. This means that the average person uses their <a rev="vote for" title="Payday Loans and Tax Rebates: How Consumers Handle Shocks" href="http://personalmoneystore.com/moneyblog/2009/10/16/payday-lo... ">tax rebates</a> and payday loans for real reasons, and is taking responsibility for themselves.

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Selena Maranjian
TMFSelena

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter...

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12/18/2014 1:10 PM
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