Reduce Taxes Now, Reduce Taxes Later

Posted on March 12, 2014 at 12:27 PM PDT by

Retirement savers often focus their energies on trying to outwit the markets. Yet that isn’t necessarily where they get the most bang for the buck in a long-term savings plan.

Few investors can beat the markets consistently over years, and even the very best professional investors lag the index for years at a time. Add in their fees and you end up coming out even farther behind.

Yet you can have your cake and eat it, too. By concentrating on so-called “tax alpha,” the long-term, serious investor can come out ahead of pack.

reduce taxes

How does it work? “Alpha,” in investing lingo, is the positive gap between what the market earned and your own portfolio. “Tax alpha” is the excess returns one gains by investing in tax-deferred and tax-free retirement plans.

First, to replicate the broad market return, you simply own index funds or index ETFs in a diversified portfolio. An ETF for U.S. stocks, another for fixed income. Smaller positions in real estate, commodities and foreign stocks and bonds.

A random walk

Using a portfolio approach and rebalancing can earn the serious retirement investor an extra 1.5% in return per year, according to calculations by Burt Malkiel, Princeton professor and author of the investment classic, A Random Walk Down Wall Street.

But that’s not tax alpha. That’s normal alpha from smart portfolio management. But consider what happens when portfolio investing occurs inside a tax-advantaged IRA.

If you use a traditional or Roth IRA to manage your money, you pay less taxes now, thanks to the pre-tax deduction you receive for saving in a qualified retirement plan. But you also get the appreciation, interest payments and dividends free of investment taxes for all the years you contribute.

In fact, you only pay taxes much later, when you take money out in retirement. Presumably, you will be in a lower income tax bracket by then, and you are not required to take money out until 70-and-a-half.

For all the intervening years, you earn the tax alpha that comes from compounding your savings in a tax-sheltered fund.

Good planning

Moreover, if you believe that your income tax bracket might be higher in retirement, you can lower those taxes by adding money to a Roth IRA. You get no tax break today in terms of your income, but you get the same tax-free growth on the appreciation, interest and dividends and then can take money out later with no income tax due.

Financial planners even talk about Roth IRAs as good estate planning tools, since you are not required to take money out at all and under certain circumstances can pass it on to heirs, who can let it compound further before having to take out principal.

In the final analysis, you have the tools to pay less taxes now, pay less in retirement and even pass on money tax-free to your family. All it takes is planning and strong, well-designed, low-cost portfolio.