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You may invest money for your IRA or self-employed plan retirement account (for example, your SEP-IRA) in stocks, bonds, mutual funds, exchange-traded funds, and even bank accounts. Mutual funds (offered in most employer-based plans) and exchange-traded funds, which I cover in detail in Chapter 8, are an ideal choice because they offer diversification and professional management. After you decide which financial institution you want to invest through, simply obtain and complete the appropriate paperwork for establishing the specific type of account you want. (Go to the later section “Choosing the Right Investment Mix” for more information.)
Taming Your Taxes in Non-Retirement Accounts
When you invest outside of tax-sheltered retirement accounts, the distributions on your money (for example, dividends) and realized gains when you sell are subject to taxation. So the non-retirement account investments that make sense for you depend (at least partly) on your tax situation.
Figuring out your tax bracket
You may not know it, but the government charges you different tax rates for different parts of your annual income. You pay less tax on the first dollars of your earnings and more tax on the last dollars of your earnings. For example, if you’re single and your taxable income totaled $50,000 during 2020, you paid federal tax at the rate of 10 percent on the first $9,875, 12 percent on the taxable income above $9,875 up to $40,125, and 22 percent on income above $40,125 up to $50,000.
Your marginal tax rate is the rate of tax that you pay on your last, or so-called highest, dollars of income. In the example of a single person with taxable income of $50,000, that person’s federal marginal tax rate is 22 percent. In other words, he effectively pays a 22 percent federal tax on his last dollars of income — those dollars earned between $40,125 and $50,000. (Don’t forget to factor in the state income taxes that most states assess.)
Any additional taxes that you would pay on additional income
The amount of taxes that you save if you contribute more money into retirement accounts or reduce your taxable income (for example, if you choose investments that produce tax-free income)
Table 3-1 shows the federal income tax rates for singles and for married households that file jointly.
TABLE 3-1 2020 Federal Income Tax Rates
| Singles Taxable Income | Married Filing Jointly Taxable Income | Federal Tax Rate |
|---|---|---|
| Less than $9,875 | Less than $19,750 | 10% |
| $9,875 to $40,125 | $19,750 to $80,250 | 12% |
| $40,125 to $85,525 | $80,250 to $171,050 | 22% |
| $85,525 to $163,300 | $171,050 to $326,600 | 24% |
| $163,300 to $207,350 | $326,600 to $414,700 | 32% |
| $207,350 to $518,400 | $414,700 to $622,050 | 35% |
| More than $518,400 | More than $622,050 | 37% |
Knowing what’s taxed and when to worry
Interest you receive from bank accounts and corporate bonds is generally taxable. U.S. Treasury bonds pay interest that’s state-tax-free. Municipal bonds, which state and local governments issue, pay interest that’s federal-tax-free and also state-tax-free to residents in the state where the bond is issued. (I discuss bonds in Chapter 7.)
Taxation on your capital gains, which is the profit (sales minus purchase price) on an investment, works under a unique system. Investments held less than one year generate short-term capital gains, which are taxed at your normal marginal rate. Profits from investments that you hold longer than 12 months are long-term capital gains. These long-term gains cap at 20 percent, which is the rate that applies for those in the highest federal income tax brackets. This 20 percent long-term capital gains tax rate actually kicks in (for tax year 2020) at $441,450 of taxable income for single taxpayers and at $496,600 for married couples filing jointly. The long-term capital gains tax rate is just 15 percent for everyone else, except for those in the two lowest income tax brackets of 10 and 12 percent. For these folks, the long-term capital gains tax rate is 0 percent.
To help pay for the Affordable Care Act (Obamacare), taxpayers with total taxable income above $200,000 (single return) or $250,000 (joint return) from any source are also subject to a 3.8 percent extra tax on the lesser of the following:
Their net investment income, such as interest, dividends, and capital gains; net investment income excludes distributions from qualified retirement plans
The amount, if any, by which their modified adjusted gross income (MAGI) exceeds the dollar thresholds; MAGI is adjusted gross income plus any tax-exempt interest income
Opt for tax-free money markets and bonds. If you’re in a high enough tax bracket, you may find that you come out ahead with tax-free investments. Tax-free investments yield less than comparable investments that produce taxable earnings, but because of the tax differences, the earnings from tax-free investments can end up being greater than what taxable investments leave you with. In order to compare properly, subtract what you’ll pay in federal as well as state taxes from the taxable investment to see which investment nets you more.
Invest in tax-friendly stock funds. Mutual and exchange-traded funds that tend to trade less tend to produce lower capital gains distributions. For funds held outside tax-sheltered retirement accounts, this reduced trading effectively increases an investor’s