Last month the advisors at Ruedi Wealth Management covered four more important topics in their "Investing 101" columns. Make sure to look for them every Sunday in The News-Gazette’s Business Extra section, but in case you missed them this past month, below are the Investing 101 columns from October.
How to Save $1,000,000
Daniel Ruedi, CFP®
A million bucks, it sounds like a lot right? For some, saving this amount seems like an insurmountable task. But if you start early and take the risk of investing your money in stocks instead of bonds or cash, it can actually be easier than you think. That is because a typical person has upwards of 30 years to save for retirement, and the magic of compounding can put a lot of wind at your back.
Let’s start with just a simple breakdown of the math. Suppose you save a certain amount at the beginning of the year each year. How much would you need to invest to save a million bucks? That answer depends primarily on 2 things: how the money is invested and how long you have to save.
When choosing investments, you have 2 main options: stocks or bonds. Going back to 1926, the S&P 500 has produced an average return of around 10%. We will handicap that number for the purpose of this example and use 9%. Bonds have historically returned less than half that, we use 4% in this example. If a person were to save for 30 years investing at 4%, they would need to save around $17,144 each year to reach $1 million. That same person investing at 9% only has to save $6,731 each year to reach $1 million. How you invest over a long time period clearly has a huge impact.
Being able to invest under $7,000 each year and still reach a $ 1million is probably surprising to some. That is the magic of compounding, but you have to make sure that it has time to take place. Though a person investing at 9% for 30 years can reach 1 million by investing only $6,731, if that same person puts off saving and only has 20 years, they would have to save $17,933 each year. A person with only 10 years to save would have to save $60,385 each year! Starting early is not just important on the path to becoming a millionaire, for most people it is essential.
Yes, this is an oversimplified example, as people don’t likely save in the form of one lump sum at the beginning of the year, and definitely don’t receive the same exact return each year they are invested. But the purpose of this example is simply to show a sense of proportion, and the message is loud and clear: if you want to save a million bucks, it is essential to start saving early and take the risk of investing in stocks. Waiting too long and investing too conservatively makes it considerably more difficult, if not impossible.
How Are Investments Taxed?
David Ruedi, CFP®
In my experience, many people are confused about how their investments are taxed. I suspect much of this confusion stems from the fact that the tax treatment of an investment depends on the type of investment account, the form of investment return, how long a person has held an investment, and a person's total taxable income for the year.
In retirement accounts, the tax treatment depends on whether you make "Traditional" or "Roth" contributions. In "Traditional" retirement accounts, you put money in pre-tax, and you don't pay taxes until you withdraw from the account. When you take withdrawals, they are taxed at your ordinary income rate. In "Roth" retirement accounts, you put money in after-tax, and the money grows tax-free from that point forward. You won't owe taxes when you take withdrawals from Roth accounts as long as they're "qualified withdrawals."
In a taxable brokerage account, you will typically owe taxes each year on the interest, dividends, and realized capital gains in the account.
Interest is paid out from bonds when you loan your money to companies and governments. This income is taxable at your ordinary income tax rate in the year it is paid. The most notable exception to this is interest from municipal bonds, which is exempt from federal taxes. In Illinois, you will still owe state taxes on municipal bond interest.
Dividends are paid by companies who want to distribute a portion of their earnings to their stock owners. The tax treatment of dividends depends if they are "ordinary" or "qualified." Ordinary dividends are taxed at your ordinary income tax rate. If the company and investors meet certain requirements, there are also "qualified dividends" which are taxed at more favorable tax rates.
Capital gains occur when an investment is sold for a gain. The tax treatment of capital gains depends on how long a person has held an investment. Gains on investments sold after being owned for less than one year, called "short-term capital gains," are taxed at your ordinary income tax rate. Gains on investments sold after being held for longer than one year, called "long-term capital gains," are taxed at more favorable rates.
For 2020, if your taxable income is less than $40,000 ($80,000 for couples filing jointly), you do not owe any taxes on qualified dividends or long-term capital gains. If you have between $40,000 ($80,000 for couples) and $441,450 ($496,600 for couples) of taxable income, then you will pay a tax rate of 15%. A person with more than $441,450 ($496,600 for couples) of taxable income would pay a tax rate of 20%.
Minimizing Taxes on Your Investments: Part 1
Paul R. Ruedi, CFP®
Nobody likes paying taxes on the money they’ve worked hard to save and invest for their future. The taxes paid over a lifetime of investing can have a big impact on the amount of money that will be available to use for future spending, but often get overlooked when making investment decisions.
Fortunately, you have many options to minimize the taxes on your investment portfolio. Some of them are so simple anyone can do them, others are more complicated and may require the help of a professional. Let’s start with a few of the easiest:
Hold Tax Efficient Investments
Index funds generally have lower turnover than actively managed funds which means fewer capital gains distributions and a lower tax bill. You can also lower the amount of buying and selling that needs to be done in the management of your portfolio by holding fewer, more broadly diversified mutual funds rather than a whole bunch of less diversified niche funds.
If you are investing in a taxable account, find out if there are “Tax-Managed” or “Tax-Advantaged” versions of the same funds you are considering investing in. Tax-managed versions of funds usually hold almost identical investments as their counterparts, but are just managed in a way that considers taxes and aims to generate the best after-tax return possible.
Invest in a Traditional 401k or IRA
In a traditional 401k or Individual Retirement Account (IRA) you invest before-tax dollars. That is, when it comes time to file taxes, the amount you contributed is deducted from income and lowers your tax bill. The proceeds grow tax-deferred, but you eventually pay taxes on withdrawals at your ordinary income tax rate at the time of withdrawal.
Invest in a Roth 401k or IRA
In a Roth 401k or Roth IRA you invest after-tax dollars (that you have already paid taxes on), your investments grow tax-deferred, and if you follow all the rules you can withdraw the funds without having to pay taxes on gains. The original amount is considered return of principal, so you don’t have to pay taxes on that either.
These are just a few of the easiest options to minimize taxes on your investment portfolio. In our column next week, we will cover a couple of the more complicated options to save on taxes. Like all investment decisions, it is important to consider your individual circumstances when determining which tax-saving strategies to implement. If you need help deciding if one of these strategies is right for you, it is definitely worth your time to talk to a financial professional.
Minimizing Taxes on Your Investments: Part 2
Paul R. Ruedi, CFP®
Last week I covered a couple of the easiest options to minimize taxes on your investment portfolio, but today I will move on to a couple slightly more complicated options:
Strategic Asset Location
Asset location, or how you divide your assets between taxable and tax-advantaged accounts, is another tool you can use to lower your taxes on your investment portfolio. You can minimize the impact of taxes on your portfolio by holding tax-efficient broad-market equity investments in taxable accounts, and by holding taxable bonds and less tax-efficient asset classes like REITs within tax-advantaged accounts, such as your 401(k) or IRA. You may also want to consider holding the highest returning assets in a Roth IRA to maximize tax-free growth.
Withdraw from your Accounts in the Correct Order
Conventional wisdom suggests that it is best to withdraw funds from your accounts in the following order: Required Minimum Distributions (RMDs) first, then taxable accounts (personal brokerage accounts), then tax-deferred accounts (Traditional 401k/IRA) and finally, tax-free accounts (Roth 401k/IRA.)
You take any Required Minimum Distributions (if applicable) from your accounts first because they are required to be taken by law. If you do not take them, you will receive a tax penalty of 50% of the required minimum distribution amount. You would then withdraw from your taxable accounts before spending from your tax-deferred accounts because it lowers the amount of income taxes paid in the beginning years of retirement, and enables as much of your portfolio as possible to continue to benefit from tax-deferred/tax-free growth.
However, this is one of those situations where conventional wisdom isn’t always the best strategy. It can lead to low taxes in the early years of retirement, but very high taxes at the end of retirement. If you’re in a low tax bracket (15% or below) in the early years of retirement, you may be better off taking a portion of your withdrawals from your IRA even if you have enough assets in taxable accounts to cover all of your spending needs. This allows you to pay taxes at your current low tax rate and avoid being taxed at potentially higher tax rates in the future.
As you can see, the above strategies are somewhat complicated. There are a lot of moving parts and “it-depends” decisions to be made when factoring in all of one’s financial variables. Though not impossible to implement yourself, they will likely require the assistance of a professional.