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Invest to Reduce Your Taxes
Just like it's important to reduce your investment fees and expenses, it's
also important to invest to reduce your taxes. Know the difference between
long term and short term gains, understand how dividends are taxed, and by
all means, put as much money as you can into tax friendly accounts such as
401Ks and IRAs.
Money that you invest in tax deferred accounts is worth more than other
money you invest. Roth IRAs and Roth 401Ks are the best, but 401Ks
and IRAs are also great ways to build wealth. By putting money in
accounts that are tax deferred or tax free (Roths), you are essentially
able to compound the investments into multiples of your initial
investment, without paying taxes. Here are the advantages of
different types of accounts and gains. You should memorize these
attributes and adjust your investments accordingly:
Long term gains - These are taxed at much lower rates than short term
gains. If possible, hold your investments at least one year to
realize a long term gain
Short term gains - Try to avoid these. Tax rates are much higher on these
investments. However, if you have losses that you probably won't
recover, use short term losses to reduce your tax bill.
Traditional IRA - Contributions to this type of account are deductible in
your current tax year and lower current taxes. They are not taxed
until you sell them, so you can compound gains for years without paying
taxes. Invest in growth stocks with these accounts when you are
younger so that you get full benefit of the tax free compounding.
Roth IRA - Contributions to these accounts are not tax deductible in the
year you make them, but you will never have to pay taxes on the value of
these accounts. That makes the value of these accounts worth much
more than a taxable account. Take more risk in these accounts to
maximize the tax free status of the funds over time.
401K - Similar to the Traditional IRA, these accounts reduce your current
taxes and compound tax free until you withdraw the money.
Dividends - Keep up with the laws on dividend taxes. Historically,
they are treated as short term gains and taxed at your income tax rate,
however, recent laws have lowered the dividend tax rate. These laws
change so adjust your investments accordingly. Sometimes, it pays to
put dividend paying stocks in a tax free account so you don't have to pay
taxes right away and can reinvest all of the dividends without penalty.
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