What to Invest In If I’m In a High Tax Bracket
How Should I Invest if I’m In A High Tax Bracket and I want to Minimize Taxes?
Help, Where to Invest If I’m In a High Tax Bracket?
The owner of Money Smart Guides asks; “What investment strategy should a couple use if they’re in a high tax bracket and want to minimize taxes on their investments?”
First off, if you’re interested in this question, congratulations. This is a nice investing problem to have.
There are actually two parts to the What to Invest In If I’m In a High Tax Bracket issue.
First, there’s the question of which investments to choose, if you’re in a high tax bracket.
Second, in what types of accounts should those investments be placed.
What Should You Invest In If You’re In a High Tax Bracket?
Recently, a few “new” entrepreneurs have been speaking to me about how to invest their recent and unexpected income. For those of you who are new to the “high tax bracket” life or those more mature folks who’ve been in a high tax bracket for awhile, there are certain strategies to help you keep taxes at bay.
Growing up, my dad was dirt poor and incredibly ambitious. In his quest to better himself he looked for any angle to maximize the money he made-and that included keeping taxes to a minimum. I was raised on “ways to keep taxes as low as legally possible”.
This section talks about what types of investments keep your taxes low.
Consider these types of investments for low tax investing:
- Municipal bonds from your state of residence.
- Tax efficient managed mutual funds.
- Traditional index funds with low turnover.
A bond is a loan to another entity in exchange for interest payments. Bonds are issued by corporations as well as governments. Most bond interest (or coupon payments) are taxable. The government issues bonds which are free of state taxes, but taxable at the federal level such as I Bonds.
Municipal bonds can be local, state and federal tax exempt.
According to Investopedia, Municipal Bonds are; “A debt security issued by a state, municipality or county to finance its capital expenditures. Municipal bonds are exempt from federal taxes and from most state and local taxes, especially if you live in the state in which the bond is issued. Also known as a “muni.”
The good news about muni’s is their current interest rates are quite competitive with those taxable bonds. To compare the yield of a muni versus a taxable bond, check out the tax equivalent yield.
Tax Efficient (Low Turnover) Managed Mutual Funds
Low turnover means the fund manager is infrequently buying and selling the holdings within the mutual fund.
Taxes are due on capital gains and dividends. You see, as long as an investment such as a stock or bond isn’t sold, there are no capital gains taxes to pay. It follows that if the fund manager is mindful of the tax implications of the mutual fund, he or she will keep selling to a minimum. This will keep your tax obligation low.
“Tax-managed funds also seek to track a particular index through a buy-and-hold strategy. They go a step further, though, by following specialized investment plans designed to minimize buying and selling of shares that could generate taxable gains. They also impose policies designed to discourage investors from frequently moving into and out of the funds.” According to the Vanguard Funds Tax Center.
Vanguard Tax-Managed Balanced Fund Admiral Shares (VTMFX) is a blended mutual fund with 50% mid and large capitalization U.S. and stocks, with the balance in federally tax-exempt municipal bonds. This sample tax managed mutual fund might be suitable for someone who wants to combine an index-oriented approach, growth of principal and a bond portfolio in one fund.
Index Funds-With Low Turnover
By their nature, index funds have low turnover and rock bottom expenses. Due to these characteristics, they are the best types of investments to reduce the tax hit on your portfolio.
“Are Stock Markets Efficient or Not?” explains the theory behind index fund investing. In short, mutual funds which track popular unmanaged indexes such as the S&P 500 tend to beat comparable actively managed mutual funds and have lower turnover with rock bottom annual expense ratios.
High tax bracket investors need to keep turnover and fees low. Municipal bonds, bought from your discount investment broker are a reliable choice for the fixed portion of your investment portfolio. Depending upon your state, you may also find a bond fund with municipal bonds from your state.
But in what types of accounts should you invest these different types of assets to minimize taxes?
Where to Invest to Keep Taxes Low
Retirement accounts, such as your IRA, Roth IRA, workplace 401(k) or 403(b) have built in tax benefits. In most cases, investing in these accounts decreases your taxable income and allows your money to grow tax free. Because of these outstanding tax benefits, it’s helpful to put assets with the highest tax consequences in these types of accounts.
Which Assets to Place in Tax Advantaged Accounts?
Corporate bonds and bond funds belong in a tax advantaged retirement account. These bonds pay regular taxable dividends.
Stock funds with high turnover should also be held in tax advantaged accounts.
Never put muni bonds in tax advantaged accounts, as you’re losing their tax benefit.
Which Assets to Place in Investment Brokerage Accounts (without tax deferral)
Place low turnover tax efficient managed mutual funds and stock index mutual funds in your discount brokerage account at Fidelity, Schwab, TD Ameritrade etc. Both of these types of funds avoid high turnover and consequently avoid high tax bills.
Realize that you’ll never eliminate tax obligations on your investments all together. Taxes are a reality that come with growing your wealth and having money to invest. But you are wise to look for ways to invest and keep more of your own money.
Readers, what are your strategies for investing and giving less to Uncle Sam?