Retirement savings inside of a 401K and IRA provide many advantages. The tax savings make it a great way to invest for retirement, but the IRS has made sure that these accounts are for that purpose only.
Investing outside of retirement accounts adds new elements to achieving maximum returns. To achieve your goals with the most efficiency, you must take into account the money you will be losing to taxes.
Common savings goals or reasons for investing outside of retirement accounts include:
- Dream homes or vacation homes
- Long term travel
- Your 401K and IRA have reached their maximum contributions.
- Early retirement
Investing in Mutual Funds with Tax Efficiency
In taxable accounts you’re getting taxed on dividends and distributions of short and long capital gains. The majority of investors, in the year 2008, are paying a tax of 15% on long-term capital gains and dividends, but up to 35% on short-term capital gains. That can be a large amount of money not earning compound interest.
Luckily for individual investors there are mutual funds that can minimize distributions and capital gains. The two most important characteristics of these funds that you will find in the fund prospectus are:
1. Turnover rate – A high turnover rate equals more buying and selling of stocks. Sales of stocks held less then a year, are taxed as a short-term capital gain You want to avoid short-term capital gains at all costs. Tax efficient accounts should have a turnover rate of less then 5%.
2. Distribution Dates and Amount – If you buy the fund today and it distributes gains tomorrow, you’re taxed the same as investors holding that fund for years. Compare the amount of times and the size of each distribution. The more per share, the more you’re taxed.
Fortunately, finding funds with that minimum taxes are not hard to find. Very broad index funds are a great place to start is, like Vanguard’s Total Stock Market Fund. It has a turnover rate of 0%, minimal distributions, plus minimal expenses.
Investors with higher tax brackets can look into tax-managed funds. These funds use strategies like loss harvesting to minimize distribution, redemption fees to reduce the holding of cash, and HIFO (High In First Out) accounting to first sell the shares you paid most for. All these strategies can significantly reduce your tax bill.
The goal to tax efficient investing is to earn the maximum return you can, while taking into account taxes. When researching for funds always look for the after-tax gains. Most mutual fund advertisements fail to report this, but a thorough search of the prospectus will not.
Earning a small return in a municipal bond but avoiding taxes will not get you closer to long-term goals. Tax efficient mutual funds allow you to get the best of both worlds.