Investment/Tax-Saving Tips for Dummies?

[DrRobert]

Can anyone provide some simple tips for long-term investing and ways to minimize taxable earnings? I'm truly a financial *****, so I like to keep things simple.

Keep in mind I'll be an attending next year, so my income won't qualify for Roth IRAs, etc.

Here are a couple strategies I've gleaned so far from this forum:

1. Money markets seem to be very "safe", but it doesn't seem like they earn a lot and I'm not sure how tax-friendly they are.

2. Mutual/Index funds also seem to be relatively safe and seem to earn more than money markets, but I'm also not sure about how tax-friendly they are.

3. Obviously buying a home can help because of the mortgage interest deduction.

4. It seems maxing out your 401K ($16.5K/year) is good because you don't pay taxes on that. But is $16.5K the pre-match limit or post-match limit?

5. I assume you have control over your 401K contributions and can funnel them into money markets, mutual/index funds, etc. as you see fit.


Basically I'm going to contribute $50K/year towards retirement and would like to funnel that cash into an uncomplicated investment portfolio that earns modest returns (lets say 10%/year over the long haul) and reduces my tax burden as much as possible.

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[UserNameNeeded]

You only have limited options in 401Ks-- you can't invest in the full universe of stocks, bonds, mutual funds, etc. that you can through most IRAs. Most 401Ks are just a means for the financial services industry to earn more fees for holding your money and giving you subpar results, IMO.

 

[nontrdgsbuiucmd]

Answers...

1) Money markets are safe? Yes, moreso than bonds, which are more safe than stocks (as a general rule), but less safe than Government bonds or funds held in bank accounts. This is based on the "risk-return" rule -- in general for an investor to accept a higher risk, they must be promised a higher return. If you're promised 100% percent return in a startup, you must expect very high risk (high chance of losing your initial investment). If you accept 2% return from an FDIC insured bank, you'd expect very low risk. This is based on a continuum; if you ever hear of a promise of 10% long-term return as Madoff's fund promised with low risk, you should be very, very suspicious.

2) mutual funds/index funds -- index funds are a basket of stocks -- depending on the type of fund, it's like investing, say, 1/500th of your funds in each of the fortune 500 firms. Fortune 500 is the list of the financially "largest" public companies traded on the US market. There is no chance of losing all of your investment, unless all 500 firms declare bankruptcy. Alternatively, you're not going to make 1000% returns like you would have if you'd been an early google investor -- with the index fund, you get lower risk + lower return.

Tax treatment is based on the vehicle in which you invest -- you can often invest in the same or a similar fund through a 401K or outside of a retirment vehicle -- if you invest through a 401K you are not taxed until you withdraw funds, hopefully decades later, versus outside the 401K you'd be taxed on the performance of the fund (this gets complicated) each year typically.

3) buying a home -- lots of threads on this, I've owned a home for many years. It's great b/c my kids have their own bedrooms, and we can landscape or upgrade appliances. But if my mortgage is 2K, that may be equivalent (after tax benefit) of paying rent on a 1,500 apartment. If I could rent a cool place for 1,200, is there a tax benefit to owning? Maybe so if real estate values go up, but this is not "guaranteed". I'd suggest buying a home if you want to have greater control over the place, not because you'd pay less tax.

4) 401K maxing -- yes this is a great way to reduce taxes. I don't max mine out now as kids are young & I'd rather put away some $$ and have more to pay for clothes, expenses, etc. Depends on what's important -- the tradeoff may be putting away $100 extra per month versus taking home $60 after taxes -- yes you can defer $40 fo taxes, but are you cool putting away that $60 for decades in the future? If you want to solely reduce taxes, you can always donate as much as you want to charity -- this will hugely reduce taxes, but also reduce $$ in your pocket.

5) directing 401K investment? this depends on your employer - large ones may offer many options, smaller employers may offer just a few options. I've worked for firms that had great options and others that had poor ones. the nice thing about this is that if you work for an employer with poor options, and then change companies, you can roll the 401K balances over to the new employer. conversely, if the new employer has poor options, typically you can leave $$ with the former employer that offers better options.

re: investment returns -- a relative was studying to become a certified financial planner (CFP). The rate of return they were advised to present as realistic was 6.9 after inflation; 10% is not realistic unfortunately. Current rates may be lower; again, if you want "guaranteed" rates, you may be offered 3%. If you will accept some risk, you may be able to get closer to 8-10% in the stock market. But you'll unfortunately never be able to simply invest funds and get a 10%, long-term rate, based on historical stock market returns and that "risk reward" paradigm.