A Taxing Investment

April 15 - The most dreaded day of the year is right around the corner. Are you ready? Some of the most neglected (and misunderstood) tax issues are those related to your investments. If you invest with taxes in mind, you can avoid a nasty surprise when Uncle Sam comes to collect.

The tax advisors are chiming in left and right on this issue. They say that you should limit yourself - and your investments - in order to minimize your tax burden for the immediate future. Those in the high tax brackets should go mainly for retirement accounts (as in tax deferred investments) and tax free investments, and those in the lower brackets should feel free to invest as they see fit. I'm sorry, but I don't necessarily agree with their synopsis.

Dividends, interest, and short term capital gains from your investments are all taxable at your standard income tax rate. Long term capital gains (that is - those coming from investments that you have held for over a year) are taxable at a lower rate. It would make sense then, for someone in a higher bracket (and thus paying a larger percentage of his or her dollar to the government) to focus primarily on limiting these types of income, and for those in lower brackets to go crazy with them, since they're not losing as much money.

Tax deferred retirement accounts, such as your IRA, 401k, or other retirement account, allow you to contribute a specific amount of money each year to your retirement. This amount is deductible from your income. That's not to say that these retirement accounts are tax free - far from it. These accounts are tax deferred, which means that you do pay taxes, though not until you take the money out. This offers the advantage of reinvesting your yields before taxes, which if done well can end up making you more money, but the fact remains that when you do access those accounts, the going tax rate may be less favorable than it is today.

Tax free investments do exist - to some extent. Municipal bonds and certain money market accounts can be tax free, however, you should always make sure that you deeply understand the taxing situation on these instruments before you actually put your money into them. In some, federal taxes or state taxes (or in some cases local income taxes) may be waived, but one doesn't imply the other, and the last thing you want is the surprise that you do owe taxes on a supposedly tax free investment.

If your portfolio has taken a little drive over the past year, you may find some solace in the fact that you can write off some of your losses. Up to $3,000 in fact. After three grand, you'll have to carry over your losses each year. This can result in a ton of paperwork, so make sure that the assessed tax difference will make up for the extra effort these filings would take.

Also make sure that you don't mix and match tax-beneficial instruments. You shouldn't put municipal bonds or tax free money market accounts in your IRA, for example. Since they're both tax free, you can end up losing out on the tax break the other provides. It's typically a better idea to use these instruments in conjunction with your regular assets. This is one of the points that I agree with the tax experts on. It just makes sense.

But I just don't agree with their investment strategy, as I mentioned before. It's all well and good to keep your taxes in mind when you're planning your investments out - and it's essential when planning for retirement - however, I just can't justify their methods. If you have had a good year financially, and find yourself in a higher tax bracket, chances are that you have a pretty nice retirement plan already. For someone making six figures, the ceiling on retirement contributions is just not enough money to be their primary focus of investment attention. If you know what you're doing, you will make money. I would much rather make money that taxed at 99% than not make a cent. It just doesn't make much sense to say that you wont invest outside your retirement account, just because you don't want it to be taxed.

Of course, if you're in a lower tax bracket, the experts recommend that you go ahead and invest in taxable securities, since your tax rate is less than, say, Bill Gates. I'm sorry, but this is ridiculous. It's pretty unnecessary for someone in a lower bracket to focus on taxable accounts alone. Actually, it's probably more important for you to pour money into your retirement accounts. With the battles going on in Washington over the "social security crisis" (which we'll touch upon next month), the best way to secure your future is to actively invest in it. If you're an active investor, splitting your investment allocated income fifty/fifty for your retirement and taxable investment accounts isn't out of line. If you don't invest very actively, and you don't think you'll need access to your retirement money, don't think twice about putting the majority of it in a tax deferred retirement account.

Essentially, my point is that your investment decisions shouldn't be held back in fear of your tax burden. If you can balance the two out, you might just find that it does make sense (and hopefully, you'll turn out more financially fit than you were before). A whole new tax year awaits, and we're ready for it.

Jonas Elmerraji is the founder and editor of growFolio, the world's first free online investment and business magazine. Issues are available online at http://www.growfolio.com

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