Keep More Investment Earnings By Reducing Taxes and Expenses

Money 2000 and Beyond Compound interest works best when income taxes are eliminated, reduced, or deferred, and when investment expenses are kept to a minimum. High income taxes and high expenses reduce investment performance. The loss of investment earnings to taxes and fees is especially painful during market downturns when investors are earning little, if anything, on their investments.

Tax-exempt investments usually provide a greater return to investors above the 10% and 15% federal tax brackets. To determine your marginal tax bracket, based on taxable income and tax filing status, consult the tax tables in your annual income tax form mailing from the IRS or visit the Web site www.rce.rutgers.edu/money2000 and click on "Resources" and "Tax Information."

Investments must be held for more than a year to take advantage of the 20% long-term capital gains tax rate (10% for investors in the 10% and 15% tax brackets). These rates have decreased further, to 18% and 8% respectively, for assets acquired after December 31, 2000 and held for more than five years.

The timing of a tax-advantaged investment also affects the amount that accumulates. Individual Retirement Account (IRA) contributions, for example, can be made on the first business day of each year up until April 15 of the following year. A hypothetical investor saving $2,000 annually in an IRA during the 20 years from 1981 through 2000 would have accumulated over $26,000 more by making contributions early in the tax year rather than waiting until the deadline of April 15 of the following year. The illustration assumes an investment asset allocation of 60% in stocks, 30% in bonds, and 10% in Treasury Bills.

Another area where catch-up investors should pay particular attention is investment expenses. Costs matter, especially over time. A hypothetical investor in a low-cost mutual fund with a 0.2% (one fifth of one percent) expense ratio (expenses as a percentage of fund assets) would have $31,701 more after 20 years than another investor in a fund charging 1.3%, on a hypothetical $25,000 investment earning 10%.

The average expense ratio for mutual funds in 2001 was 1.34% ($13.40 per $1,000 of assets). Many investors are paying more than this, however, particularly for mutual funds that charge a 12b-1 fee of up to 1% of assets for marketing and distribution expenses. Tax efficiency also matters. While investors can't control investment performance, they can select tax-efficient mutual funds that minimize the expenses and taxable distributions that are passed on to investors.

Review the list below to determine whether or not you are taking advantage of available tax breaks that can result in decreased income taxes and increased retirement savings. The more strategies that you check off, the more savvy you are as a tax-advantaged investor.

Tax-Advantaged Investment Strategy


  1. Participate in a tax-deferred employer retirement savings plan (e.g., 401(k) plan)
  2. Contribute the percentage of pay (e.g., 6%) required to earn the maximum match from employer
  3. Contribute the maximum amount of savings allowed in employer plan
  4. Take advantage of additional employer savings plan catch-up contributions for workers age 50 and over
  5. Fully fund an IRA for self with earned income
  6. Fully fund an IRA for spouse (whether or not spouse is employed)
  7. Take advantage of IRA catch-up contributions for workers age 50 and over
  8. Make IRA contributions early in the tax year
  9. Invest in a tax-deferred plan for self-employed persons (e.g., SEP, Keogh)
  10. Hold investments for more than a year to take advantage of long-term capital gains tax rates
  11. Invest in tax-deferred annuities with after-tax dollars after funding employer plan and IRAs
  12. Increase retirement plan savings as income increases and/or household expenses decrease

  1. Rutgers
  2. Executive Dean of Agriculture and Natural Resources
  3. School of Environmental and Biological Sciences