From Here to Financial Happiness

Day Sixty Cutting Taxes

As you seek to hold down investment costs, you should also pay attention to the biggest investment cost of all – taxes. How do you do that? Follow four simple rules.

First, make the most of tax‐favored retirement accounts. A 401(k) or similar employer‐sponsored retirement plan can give you the investor's triple play: an immediate tax deduction, tax‐deferred growth and a matching employer contribution. If you qualify, a traditional IRA can give you the double play: a tax deduction and tax‐deferred growth.

What about a Roth IRA or Roth 401(k)? There's no immediate tax deduction, but money withdrawn in retirement can be totally tax‐free. By contrast, with non‐Roth retirement accounts, you have to pay income taxes when you make withdrawals. Tax‐deductible accounts make the most sense if you expect to be taxed at a lower rate once retired, while Roth accounts are more appealing if you expect your tax bracket in retirement to be the same or higher.

Second rule: Avoid earning a lot of interest income in your regular taxable account. Interest income – such as the income kicked off by bonds and savings accounts – is immediately taxable at your marginal income tax rate (though interest from some federal government bonds isn't taxable at the state level and interest from municipal bonds may be completely tax‐free). Do you pay tax at, say, a 12%, 22%, or 24% rate on any additional dollars you earn? That's your marginal tax rate – and that's the cut that Uncle Sam ...