Tax planning to save and improve returnStrategies for Outsmarting Uncle Sam at Tax Time

As we approach year-end, investors should start to focus on tax planning. Given the volatile state of the markets, and the steady drumbeat of bad news, this is not easy.

Here are some tips to avoid taking a big tax hit in 2010.

Max out a Roth IRA contribution. Tax avoidance is the holy grail of tax planning. The best tax-avoidance investment is the Roth IRA. First, you need to determine if you qualify. You can find the applicable contribution rules here.

Here are some general guidelines: If you are married filing jointly and your modified adjusted gross income is less than $167,000, you can contribute the maximum of $5,000 (or $6,000 if you are 50 or older) to a Roth. If you are single, the adjusted gross income figure is less than $105,000.

While there is no tax deduction for Roth IRA contributions, you won’t pay any taxes on withdrawals, no matter how much your account appreciates in value. If you don’t need the tax break immediately, the Roth IRA is a great way to avoid paying taxes.

Contribute to a Roth 401(k). I don’t understand why every 401(k) plan doesn’t offer a Roth 401(k) option. True, you don’t get a tax deduction like you do with contributions to a traditional 401(k), but check out these benefits:

There are no income limits for those who contribute to Roth 401(k)s. This is great for high-income earners. They may not qualify for a regular Roth IRA, but they can contribute to a Roth 401(k).

Contribution limits for a Roth 401(k) are generous: $16,500 for 2010, or a whopping $22,000 for those 50 or older.

While predicting future tax rates is risky business, many experts take a look at our deficits and believe ordinary income rates are likely to rise. If so, you are better off taking the tax hit now, and reaping the rewards of tax-free income later.

Consider tax-deferred investments. You can defer the inevitable, even if you can’t avoid it. Consider tax-deferred investments like traditional IRAs, Keogh plans, regular 401(k)s, 403(b) plans, 457(b) plans, and defined-benefit plans (if you are lucky enough to have one). Investing in these plans at the end of the year is better than not doing so at all, but next year, don’t wait until the last minute. The difference between investing at the beginning of the year and the end can be significant over the long term.

Also, annuities and whole life insurance can be excellent vehicles for tax deferral. I don’t believe variable annuities are suitable for most investors, but the often-overlooked fixed-income annuity (from low-cost providers like Vanguard and TIAA-CREF) is worthy of consideration. Cash-value whole life is much maligned by investment experts, but some policies (like blended insurance, which combines the benefits of whole life and term insurance) can be a wise addition to your portfolio.

Invest in low-cost index funds. You can significantly reduce the amount of taxes you will pay even in your after-tax accounts. According to one study by Vanguard founder John Bogle, over a sixteen-year period, taxes gobbled up 20 percent of the returns in actively managed mutual funds (where the fund manager attempts to beat a designated benchmark). In comparable index funds, the tax hit was only 11 percent. When Bogle considered all costs in actively managed and index funds, he found investors in index funds kept 87 percent of their returns, versus a paltry 47 percent in actively managed funds.

Saving on taxes and improving returns are two of the many reasons to confine your investments to a globally diversified portfolio of low-cost stock and bond index funds.

Dan Solin is a Senior Vice-President of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read, and The Smartest Retirement Book You’ll Ever Read. His latest book is Timeless Investment Advice.

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