Making the most of your investment options

No hard-and-fast rules dictate how to allocate the percentage that you’ve
earmarked for growth among specific investments like stocks and real estate.
Part of how you decide to allocate your investments depends on the types of
investments that you want to focus on. As I discuss, diversifying
in stocks worldwide can be prudent as well as profitable.
Here are some general guidelines to keep in mind:
✓ Take advantage of your retirement accounts. Unless you need accessible money for shorter-term non-retirement goals, why pass up the free
extra returns from the tax benefits of retirement accounts?
✓ Don’t pile your money into investments that gain lots of attention.
Many investors make this mistake, especially those who lack a thoughtout plan to buy stocks.  I provide numerous illustrations of
the perils of buying attention-grabbing stocks.
✓ Have the courage to be a contrarian. No one likes to feel that he is
jumping on board a sinking ship or supporting a losing cause. However,
just like shopping for something at retail stores, the best time to buy
something of quality is when its price is reduced.
✓ Diversify.the values of different investments
don’t move in tandem. So when you invest in growth investments, such
as stocks or real estate, your portfolio’s value will have a smoother ride
if you diversify properly.
✓ Invest more in what you know. Over the years, I’ve met successful
investors who have built substantial wealth without spending gobs of
their free time researching, selecting, and monitoring investments. Some
investors, for example, concentrate more on real estate because that’s
what they best understand and feel comfortable with. Others put more
money in stocks for the same reason. No one-size-fits-all code exists for
successful investors. Just be careful that you don’t put all your investing eggs in the same basket (for example, don’t load up on stocks in the
same industry that you believe you know a lot about).

Considering your age

When you’re younger and have more years until you plan to use your money,
you should keep larger amounts of your long-term investment money in
growth (ownership) vehicles, such as stocks, real estate, and small business.
As I discuss in Chapter 2, the attraction of these types of investments is the
potential to really grow your money. The risk: The value of your portfolio can
fall from time to time.
The younger you are, the more time your investments have to recover from
a bad fall. In this respect, investments are a bit like people. If a 30-year-old
and an 80-year-old both fall on a concrete sidewalk, odds are higher that the
younger person will fully recover and the older person may not. Such falls
sometimes disable older people.
A long-held guiding principle says to subtract your age from 110 and invest the
resulting number as a percentage of money to place in growth (ownership)
investments. So if you’re 35 years old:
110 – 35 = 75 percent of your investment money can be in growth
investments.
If you want to be more aggressive, subtract your age from 120:
120 – 35 = 85 percent of your investment money can be in growth
investments.
Note that even retired people should still have a healthy chunk of their
investment dollars in growth vehicles like stocks. A 70-year-old person may
want to totally avoid risk, but doing so is generally a mistake. Such a person
can live another two or three decades. If you live longer than anticipated, you
can run out of money if it doesn’t continue to grow.

These tips are only general guidelines and apply to money that you invest for

the long term (ideally for ten years or more). For money that you need to use

in the shorter term, such as within the next several years, more-aggressive

growth investments aren’t appropriate. See Chapters 7 and 8 for short-term

investment ideas.

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 federaltax-free and also state-tax-free to residents in the state where the bond is
issued.
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 15 percent,
except for those in the two lowest tax brackets of 10 and 15 percent. For
these folks, the long-term capital gains tax rate is just 5 percent.
Use these strategies to reduce the taxes you pay on investments that are
exposed to taxation:
✓ 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 funds that tend to trade less
tend to produce lower capital gains distributions. For mutual funds
held outside tax-sheltered retirement accounts, this reduced trading
effectively increases an investor’s total rate of return. Index funds are
mutual funds that invest in a relatively static portfolio of securities, such
as stocks and bonds (this is also true of some exchange-traded funds).
They don’t attempt to beat the market. Rather, they invest in the securities to mirror or match the performance of an underlying index, such as
the Standard & Poor’s 500 (which I discuss in Chapter 5). Although
index funds can’t beat the market, the typical actively managed fund
doesn’t either, and index funds have several advantages over actively
managed funds. See Chapter 8 to find out more about tax-friendly stock
mutual funds, which includes some non-index funds, and exchangetraded funds.
✓ Invest in small business and real estate. The growth in value of business and real estate assets isn’t taxed until you sell the asset. Even then,
with investment real estate, you often can roll over the gain into another
property as long as you comply with tax laws. However, the current
income that small business and real estate assets produce is taxed as
ordinary income.
Short-term capital gains (investments held one year or less) are taxed at your
ordinary income tax rate. This fact is another reason that you shouldn’t trade
your investments quickly (within 12 months).

Figuring 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 2011, you
paid federal tax at the rate of 10 percent on the first $8,500, 15 percent on the
taxable income above $8,500 up to $34,500, and 25 percent on income above
$34,500 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 25 percent. In
other words, he effectively pays a 25 percent federal tax on his last dollars of
income — those dollars earned between $34,500 and $50,000. (Don’t forget to
factor in the state income taxes that most states assess.)
Knowing your marginal tax rate allows you to quickly calculate the following:
✓ 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)

Choosing retirement account investments

When you establish a retirement account, you may not realize that the retirement account is simply a shell or shield that keeps the federal, state, and
local governments from taxing your investment earnings each year. You
still must choose what investments you want to hold inside your retirement
account shell.
You may invest your IRA or self-employed plan retirement account (SEP-IRAs,
Keoghs) money into stocks, bonds, mutual funds, and even bank accounts.
Mutual funds (offered in most employer-based plans), 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. (Flip to the later section
“Choosing the Right Investment Mix” for more information.)

Taming Your Taxes in NonRetirement Accounts
When you invest outside of tax-sheltered retirement accounts, the profits and
distributions on your money are subject to taxation. So the non-retirement
account investments that make sense for you depend (at least partly) on
your tax situation.
If you have money to invest, or if you’re considering selling current investments that you hold, taxes should factor into your decision. But tax considerations alone shouldn’t dictate how and where you invest your money. You
should also weigh investment choices, your desire and the necessity to take risk, personal likes and dislikes, and the number of years you plan to hold the
investment (see the “Choosing the Right Investment Mix” section, later in the
chapter, for more information on these other factors).

Annuities

If you’ve contributed all you’re legally allowed to contribute to your IRA
accounts and still want to put away more money for retirement, consider annuities. Annuities are contracts that insurance companies back. If you, the annuity
holder (investor), should die during the so-called accumulation phase (that is,
prior to receiving payments from the annuity), your designated beneficiary is
guaranteed reimbursement of the amount of your original investment.
Annuities, like IRAs, allow your capital to grow and compound tax deferred.
You defer taxes until you withdraw the money. However, unlike an IRA that
has an annual contribution limit of a few thousand dollars, you can deposit
as much as you want in any year to an annuity — even millions of dollars, if
you’ve got it! However, as with a Roth IRA, you get no upfront tax deduction
for your contributions.
Because annuity contributions aren’t tax-deductible, and because annuities
carry higher annual operating fees to pay for the small amount of insurance
that comes with them, don’t consider contributing to one until you’ve fully
exhausted your other retirement account investing options. Because of their
higher annual expenses, annuities generally make sense only if you have 15 or
more years to wait until you need the money.

IRAs

If you work for a company that doesn’t offer a retirement savings plan, or
if you’ve exhausted contributing to your company’s plan, consider an individual retirement account (IRA). Anyone with employment income (or who
receives alimony) may contribute up to $5,000 each year to an IRA (or the
amount of your employment or alimony income if it’s less than $5,000 in a
year). If you’re a nonworking spouse, you’re eligible to put up to $5,000 per
year into a spousal IRA. Those age 50 and older can put away up to $6,000 per
year (effective in 2011).
Your contributions to an IRA may or may not be tax-deductible. For tax year
2011, if you’re single and your adjusted gross income is $56,000 or less for the
year, you can deduct your full IRA contribution. If you’re married and you file
your taxes jointly, you’re entitled to a full IRA deduction if your AGI is $90,000
per year or less.
If you can’t deduct your contribution to a standard IRA account, consider
making a contribution to a nondeductible IRA account called the Roth IRA.
Single taxpayers with an AGI less than $107,000 and joint filers with an AGI less
than $169,000 can contribute up to $5,000 per year to a Roth IRA. Those age 50
and older can contribute $6,000. Although the contribution isn’t deductible,
earnings inside the account are shielded from taxes, and, unlike a standard
IRA, qualified withdrawals from the account are free from income tax.