Income Taxes

Free Money? Here’s How:

A great tax strategy is like free money falling from the sky. Different than offers on the internet and in the mail, this cash isn’t attached to some come-on. Usually, I’ll get phone calls from a telemarketer badgering me. I accept a free room at a hotel and spend the next day saying “no thank you” to time-share hustlers. Tax strategies, though, are the free money that just keeps giving.

You, too, can have a free investment return if you plan correctly.

Back when I was a financial advisor, I’d talk to people about investments, and it always seemed like people were searching for the next “hot” issue that’ll bring a huge return. Oil? That seems like a great buy. Gold? That must be a great investment. Penny stocks? I’ve heard you can make a killing there. These might be all be fantastic investments for aggressive investors, but there is another area that’s so boring, so un-sexy that investors ignore it. Want to know the most boring high return investment in town?

A good tax strategy.

I can hear the yawns already. But wait, this really is free cash with no downside. No telemarketer calls or time shares to see. How come investors will do everything to find 3 or 4 percent more money but ignore great tax treatment of their money?

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Here’s why you should pay attention to tax shelters first before worrying about investments:

Let’s say that you place $10,000 into a 401k or IRA and earn a paltry 5 percent return. Another investor, we’ll call him “Mister Stock Guru”, earns a whopping 10 percent without any tax shelter. Both of these investors are in the 25 percent tax bracket and investment gains are taxed at a 20 percent tax rate. The fun begins the moment you invest in the tax shelter. For many, an investment in the 401k or IRA gives you an immediate tax break equal to your tax bracket. In this example, you start with $2,500 more than Mister Stock Guru.

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It turns out you were smarter than the person who could find huge investment returns.

Here’s the statistic: It takes Mister Stock Guru a full four years of double your returns to match your initial investment! Why? It’s all because you ignored the stock market and instead focused on the boring tax shelter side of the equation.

IRA and 401k plans aren’t best for every investor. These are great retirement plans, but are rotten for short term goals. More flexible funds can still be sheltered in Roth IRA plans. These give investors no up-front tax benefit, but money grows tax free for life if taken out during retirement. Money in these plans have less restrictions if you need cash before retirement.

Don’t get me wrong; picking investments is still important. You should focus on three points before investing any cash to wring the maximum return out of each dollar:

1)      Determine when you’ll need money. If you need funds for short-term goals, you’re going to save into different plans than if you need money far into the future.

2)      Find the right tax shelter for the plan. If it’s a long term goal, workplace 401k plans or an IRA should be explored. For shorter goals, see if you can use a Roth IRA or 529 college savings plan.

3)      Decide which investments to use for your goal.

Many investors get so caught up in the “hype” of investments that they start at the bottom of our three point plan. By working from the top, you’ll find yourself with some free cash that you wouldn’t have had if you’d only focused on “hot” investments.