Taxes: Minimize Portfolio Taxes - Ch 11 Boglehead Series at Catch a Gideon

November 16th, 2006 by digerati

This is Chapter 11 in the Bogleheads series here at Catch a Gideon. We are going through each chapter in the book and letting you know what we learned from reading it. You should buy the Bogleheads Guide to Investing. It has more examples and more depth than I’m giving here, and is overall an excellent investment book.

This is the second chapter on taxes in the book. Chapter 10 of the Bogleheads Series covered taxes on mutual funds. This chapter is about managing your portfolio for maximum tax efficiency.

The best way to minimize taxes is to use tax sheltered accounts. These include 401(k), IRA, 403(b) and Roth equivalents. Unfortunetly these plans are very complex. This chapter gives an overview of the types of accounts available.

401(k) Plans

This is a deferred compensation plan. An employee may contribute to the account with pre-tax income. That means that if you contribute $5,000 into the account you can report your taxable income as $5,000 less than otherwise. The limit for contributions is currently $15,000 (in 2006). Catch up contributions are allowed if you are over 50.

Benefits:

can also have other retirement plans
automatic withholding from your paycheck
flexibility in the contribution amount
many employers match contributions
higher contribution limit than other retirement options
tax free growth in the account
choice of investment options
can deduct money for certain “hardship expenses”
it’s portable (when you switch jobs you take it with you or roll into an IRA)
protection from creditors

Disadvantages:

administrative costs are typically high
many have poor investment options
information and advice to employees is often inadequate
access to your money is restricted

Plans are often expensive for the emplyers. There are several types of fees that add into these costs:

plan administrative costs
investment fees
individual service fees
sales commissions

403(b) Plans

These plans are for non-profit entities rather than for profit (which use the 401(k) plans). They generally work in the same manner, but often offer a different set of investments. The disadvantage is that many times these investments are held in annuities.

An advantage is that many 403(b) plans have an escape hatch allowing you to instead move your money to an outside 403(b) provider such as T Rowe Price or Fidelity. This would allow you to manage the account yourself.

IRA - Individual Retirement Account

An IRA is a personal savings plan with tax benefits aimed at retirement. Contributions are tax deductible and the earnings are not taxed until they are distributed. The 2006 contribution limit is $4000, though this is set to increase in the next few years. IRA withdrawals are taxed at the investor’s marginal tax rate. There is a 10 percent penalty for withdrawing money from the IRA until the investor reaches the age of 59.5 (though there are exceptions).

There are also “nondeductible IRAs” which the book does not recommend.

Roth IRA

A Roth IRA allows you to place after tax income into a savings account. However, distributions from the Roth IRA are not included in income. Basically you are trading paying taxes now for not paying taxes later. This is a good idea when you are in a lower income bracket now than you plan to be later. For this reason, the income cap for a Roth IRA is about $100,000.

You can usually convert a traditional IRA into a Roth IRA, but you will have to pay taxes on the amount converted.

Thats it for chapter 11! Keep in mind that I leave alot of detail out that is in the book. You should really go buy the Bogleheads Guide to Investing to fill in the rest. Or, of course, you can just keep reading the site!