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Rule #8: Minimize taxes with IRAs, Roth IRAs, 401(k)s and other accounts | Investing for beginners - YouTube
Channel: FinancingLife
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Two things that every investor should know
to be a smart taxpayer are that: not all income
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is taxed the same, so you generally want to
hold bonds in a retirement account and stocks
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in a taxable account.
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To understand this, let's consider Sharon
and Mark's retirement account.
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We always start with a long-term plan which
includes choosing risk and asset allocation
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before worrying about taxes.
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They have decided that the correct risk level
for their retirement portfolio is 60% stocks
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and 40% bonds, increasing the allocation to
bonds by 1% every year.
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Their preference is own total stock market
index funds, with 2/3 from US companies and
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1/3 from international companies.
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For bonds, they chose a total US bond market
index fund.
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They've got taxable, tax-free, and tax-deferred
accounts.
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Tax-advantaged accounts are the most tax-efficient
place to invest so you'll want to take maximum
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advantage of these.
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Sharon's been contributing to a Roth IRA with
some of their after-tax earnings every year.
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All the growth in this account will be forever
tax-free.
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Mark has a 401(k) retirement program with
his employer.
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This, like traditional IRA Accounts, is all
tax deferred.
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They pay no taxes on income he invests here,
or on any growth of these investments, until
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he uses it during retirement when it all gets
taxed as ordinary income.
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Best of all, his company matches some of his
contributions.
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Let's consider their tax situation.
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As they earn more income, the last dollars
they earn get taxed at higher levels.
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Say they are in the 25% marginal tax bracket.
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While they pay less than 10% of their total
gross income on federal income taxes, the
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important thing is that of the last dollar
they earned in wages, 25% went to these taxes.
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Now to the first point of this video.
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Let's consider how their investments get taxed.
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It turns out that the interest and dividends
that you earn from your bonds, bank CDs, and
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savings accounts are all taxed like ordinary
income.
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Now with stocks, you own a portion of these
companies and they distribute some of their
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profits with you as dividends.
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Secondly, as the company grows, the value
of the shares appreciate.
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So you hope to sell it for a higher price
in the future.
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If hold the stock for a long time and the
price goes up, not only do you get to defer
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paying taxes on the appreciation until you
sell it, but this long-term-capital-gains
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tax is at a lower rate.
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There's more good news.
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Currently the earnings that are distributed
every year as qualified dividends are also
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taxed at this lower rate!
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Now some mutual funds that are actively managed
do lots of buying and selling, trying to beat
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the market.
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This turnover creates extra capital gains
that we have to declare and pay taxes on now,
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instead of deferring these into the future
like we would prefer.
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The best mutual funds are going to have low
turnover in addition to being low-cost and
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widely diversified.
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The best choices are usually index funds,
but they aren't always.
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It's these attributes that are important.
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Getting back to our example: after they've
considered risk and asset allocation, Sharon
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and Mark determine the tax efficiency of each
of their investment assets.
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We want to place the bonds in their tax-deferred
retirement account, or more precisely, those
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investments that have the highest tax cost.
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This is the main point.
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So if you only remember one thing, remember
this.
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Other recommendations: generally keep your
foreign stocks in your taxable account where
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you can get a foreign tax credit.
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And usually put the fund with the highest
expected return into a tax-free Roth IRA.
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Fill up the remaining space in your tax-advantaged
accounts with tax-efficient stock funds, and
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then hold the rest in a taxable account.
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For this example, here is how it ends up looking.
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There are many other benefits to having stock
funds in a taxable account, so I'll provide
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you links to these topics if you want to explore
them.
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One topic that will impact all of you is record-keeping
for your taxable account, since you usually
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want to keep track of the cost of every share
that you buy so that when you sell it you
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can sell the highest cost shares first.
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I've got a link to tips for this as well in
the transcript to this video.
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Find other explanatory videos, smart tips,
and links to useful resources at FinancingLife.org.
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