Investing is not only about generating profits it is also about maximizing them while taking the less possible risk. Remember that there are differences between an investor and a stock trader. An investor is interested in holding shares for a long period of time while a trader is more interested in price swings and volatility to generate profits. There have been enough studies that confirm that long term investing generates better results for the average Joe than trading especially if investments are made in companies that pay dividends year after year. As companies increase dividends the income that the shareholder receives goes up especially if the stocks are enrolled in a DRIP program taking advantage of the compounding effect as dividends and income generate even more income and higher dividends.
However, there is a little problem associated with dividend stocks, bonds, mutual funds or anything that churns out cash on a regular basis. The problem is that whenever you receive any type of income Uncle Sam is also waiting for a slice of the pie. When starting out, many investors are not aware of the consequences that dividend income taxes have on the return of an investment until they realize that over the years their dividend taxes start to grow faster and faster until they start to get scary. It doesn’t matter if you are investing in stocks, bonds, mutual funds or any other type of security; you have to pay Uncle Sam his share or you will run into trouble with the IRS. There is no way around it or is it?
To our relief there are some ways to get around taxes that are suited for those that are accumulating assets to live comfortably through the golden years. Programs such as a 401k and tax deferred accounts such as traditional and Roth IRAs are the bread and butter for investors that want to end up wealthy and live a comfortable life.
How Taking Advantage of Tax Advantaged Accounts Will Make You Richer
Say your own some dividend stocks and you enroll them in a DRIP program. Every year you will have to pay Uncle Sam taxes on the income received from those investments. Since your shares are enrolled in a dividend reinvestment program the income received is automatically reinvested into more shares of the company. When taxes are due you would have to calculate taxes owed to the IRS and would have to pay them either from your salary, savings or even your piggy bank. If your shares are not enrolled in a dividend reinvestment program the income received would be sent to your home or deposited into your brokerage account for you to use it or reinvest but you still owe taxes. Even worst, if you are reinvesting proceeds on a regular basis you are paying fees on buy orders. While it may appear that taxes and fees are not much over the long term the difference is huge when the annual compounded rate is calculated. Just a difference of 2% on the annual compounding rate of your portfolio is a lot after fifteen years imagine if you are investing to retire thirty years from now! When you are investing over the long term every penny you get to keep from your investments makes you richer.
Maximizing Investing Profits Using Tax Advantaged Accounts
Not all of us are investing only for retirement we have other things in life to cover and other goals. Sometimes we want to invest to have more money a few years from now or like to keep some assets as a reserve in case something goes wrong or some emergency arises. Whatever your motives you can get the most out of your investments by having a tax advantage account in addition to your regular brokerage account. Here is a way to maximize the total lifetime returns of your portfolio through asset allocation:
The best investments to hold in tax advantaged accounts are high yielding securities. Since you don’t have to pay taxes on the income received from those securities until the time you retire, you will have more money compounding for you. Even better, if your tax advantaged account is a Roth IRA you pay your taxes first and don’t have to pay federal taxes when you start your distributions at the time of retirement. For this reason some of the best investments to hold in IRAs and 401ks are high yield blue chip stocks, corporate bonds, REITs, mortgage REITs, dividend ETFs, and yield oriented mutual funds. Some closed end mutual funds that focus on high dividends are also great additions to any IRA or 401k. To get the most out of these investments you can set dividend stocks and some other securities such as REITs and closed end funds in a DRIP program if your broker allows it. If not, change your brokerage house because there are many online brokerage houses that allow you to enroll many types of securities in dividend reinvestment programs for free without charging you in any way.
What to Hold in Your Regular Brokerage Accounts
In regular brokerage accounts it is better to hold investments such as stocks that don’t pay dividends or those that have low yields and low dividend growth. You would still need to pay Uncle Sam a chunk of the profits you receive when you sell your shares but if the shares were held for more than a year you would be paying a capital gains tax of only 15% compared to the 30% you would be paying on a distribution from a traditional IRA. In the case that you have a Roth IRA the story is different since you won’t be paying taxes at retirement but still, if you want capital accessible for other things in life, securities that don’t pay or that pay little dividends or income are the best to hold in a regular brokerage account. Remember that your goals and how you approach the stock market may be different. If you are a trader that lives from trading daily, weekly or monthly then you would need a regular brokerage account to do your trades and generate your income.
In conclusion, a tax deferred account such as an IRA or a 401k plan is one of the best assets to those that are looking to retire rich and grow their net worth over the years. The difference that taxes have on the return of a portfolio get bigger as compounding get more noticeable as compounding takes place and the income generated grows.