The Legal Way to Avoid Getting Taxed on Your Investments

by Carlos Portocarrero on 9 March 2010 6 comments

Tax time is coming, and that means trying to keep as much of our hard-earned money as we can. That may or may not make us tax hypocrites, but it's the truth: no one wants to pay more than we have to.

In order to follow my tip, you'll need two things: a tax protected account like a Roth IRA and a stock or mutual fund you like that pays a dividend.

First Things First

You'll notice I italicized "you like" in that last sentence: that's important. Before you even decide to go down this route, you need to find an investment you like and want to own regardless of this strategy. I don't care if you think it's going up because you read something in a annual report, an analyst likes it, or because your palm reader told you.

Just make sure you have a reason and you like it.

As for the dividend: don't focus so much on how big of a yield it is; the important thing is that it pays one out. You may also want to check:

  • How long have they been paying one? The longer the better.
  • Have they ever lowered it? Not great.
  • Do they have a track record of consistently increasing it? Very nice!

I could spend hours on how to pick and investment, but not here. Once you have an investment you like that pays dividends, you can move on to part II.

FYI: If you're interested in investing in real estate and dividends, check out REITs.

Tax Sheltered Account

My favorite is the Roth IRA because the money you use to fund it has already been taxed. So once you put money in here you'll never have to worry about taxes again.

Now what you do is buy the stock/mutual fund from step one inside this account and boom—you're done!

Wait, that sounds too easy doesn't it? There is one more thing you have to double check: does your brokerage allow you to reinvest the dividends automatically, free of charge?

This is important because if they don't, the dividend payments will be credited to your account instead of being automatically reinvested. That means the money has to be contributed into the account instead of automatically going in. And it means it'll eat into the limits ($5,000 for 2010) set up for accounts like Roth IRAs.

Most brokerages will automatically reinvest dividend payments from mutual funds, but not for individual stocks, so make sure ahead of time that this is all set up.

Why This Strategy Rocks

  • You aren't taxed on the dividends you get paid
  • You get to contribute the dividend automatically
  • You set it and forget it: as long as you still like the stock/mutual fund you don't have to do anything

The Downside

  • You can't touch this money until you retire, so you aren't going to get rich quick with this

If you want to read more about this strategy, check out my post on investing in real estate without taking a tax hit.

Thanks to Dangerman for the corrections on dividends counting towards your contribution!

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Guest's picture
Dangerman

..."the dividend payments will be credited to your account instead of being automatically reinvested. That means the money has to be contributed into the account instead of automatically going in. And it means it'll eat into the limits ($5,000 for 2010) set up for accounts like Roth IRAs."

Completely and 100% wrong.

Dividends or interest paid from an investment that is inside an IRA remain in the IRA and do not count against the contribution limit. Those dividends or interest may either be reinvested in that same investment inside the IRA, or the brokerage will put them in a "sweep" account INSIDE the IRA.

Retraction/correction needed.

Guest's picture
Sean

Echoing what Dangerman said: The only thing that counts against your contribution limits are, well, your contributions.

Guest's picture
Dangerman

I think you still don't get it. The whole basis for this article is pretty off base.

Namely, the statement "That means the money has to be contributed into the account instead of automatically going in." is still wrong: the money (from the dividends) does NOT have to be "contributed into the [IRA] account." The dividend money is already inside the IRA account. The dividend money merely has to be _invested_ in the specific stock/mutual fund/etf etc if you choose not to reinvest the dividends.

Furthermore, the statement "You get to contribute the dividend automatically" is wrong: the word "contribute" legally means to put new money into the IRA. Dividends from an investment that is already inside the IRA are not "contributed."

But more generally, inside an IRA, you don't care whether the increase in value comes from dividends being reinvested or from capital gains... since you don't pay taxes on either. So there's no reason to use this strategy at all.

Just pull the article, Wise Bread is better than this.

Carlos Portocarrero's picture

The basis of the article is most definitely not "off base." The focus here is on not having to pay taxes on dividends, and especially on high-dividend paying securities—by holding them in a tax-protected account.

That's a valuable piece of information for would-be investors out there.

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Guest's picture
Raymer

This is a good concept that needs some further clarification. The "downside" of "you can't touch this money until you retire" is not entirely accurate.

Roth IRAs are accessible in a number of ways prior to retirement. You can withdraw your contributions at any time for any reason. Also, qualified first time home purchases, certain medical expenses, and disability are also acceptable reasons to take early distributions.

Just to be clear, we should also probably define retirement. Just because you decide that you are "retired" does not mean that you can begin distributions from your IRAs. In most cases, you must reach age 59 1/2 to avoid penalty and in the case of the Roth, you must have an account set up for at least five years. There are strategies available under the tax code for early IRA distributions but they must be set up properly to avoid penalty.

All that being said, putting an investment that generates current and unneeded income in a tax sheltered vehicle is often a sound strategy.

Guest's picture
Steven

I've always thought capital gains taxes were the worst of them all. You make sound investments instead of throwing your money away and then you get penalized for it?