The Legal Way to Avoid Getting Taxed on Your Investments
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
- 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!