Boost Your Income: Lower Your Tax Bill

Taxes eat up a large chunk of your employment earnings. If you're in the top 35% marginal bracket, you typically keep just 68 to 73 cents of every dollar you earn. Your investment returns also are vulnerable to taxes, which can have a huge impact on your money's growth over time.

Indeed, taxes swallowed nearly 15% of the average U.S. diversified equity fund's gross return during the 10 years through 2006, according to a Lipper study.

"Those are big numbers," says Rick Shapiro, a managing member of Investment and Financial Counselors in West Hartford, Conn. "The key isn't just returns but after-tax returns. How you deal with your taxes can make a big difference to your bottom line."

As always, it's a good idea to check with your accountant or tax adviser on tax matters. That said, here are some strategies for limiting your tax bill and boosting your after-tax income:

Maximize Deductions

As tax law becomes more complex, claiming all available deductions becomes more difficult. "People miss all kinds of deductions," says Shapiro, who is also a CPA with a master's degree in taxation. "They can really add up."

Indeed, nearly 2.1 million filers failed to claim the state sales tax deduction on their 2006 federal returns, according to the Treasury Inspector General for Tax Administration. Those oversights amounted to nearly $3.6 billion in missed deductions and $534 million in refunds. If you pay state income tax, you have the option of deducting that or the sales tax you paid over the year. (Residents of the seven states without income tax can simply claim the state sales tax they paid.)

You might miss deductions even if your tax return is relatively simple. Take charitable giving. In order to deduct donations of $250 or more, you must have a receipt. But it's worth tracking smaller donations, too, because those $25 checks to friends' charity walks can add up. Consider your noncash donations, too -- from mileage driven for charity (14 cents per mile) to the trunkload of clothes you gave to Goodwill. Good records will allow you to deduct every penny of such gifts' value.

Tax credits are even better than deductions, because they reduce your actual tax bill -- not just your taxable income. Many filers forget about the child care credit (up to $3,000 in work-related child care expenses, depending on income). Most credits are directed toward low-income filers, so if you don't earn much, you're especially likely to benefit from them.

Max Out Tax-Advantaged Plans

The best way to boost your after-tax investment returns is to maximize contributions to retirement savings accounts, including 401(k)s or other employer-sponsored plans as well as self-directed plans such as individual retirement accounts (IRAs).

Both 401(k)s and IRAs come in two varieties: traditional and Roth. You can contribute pretax income to a traditional plan -- in 2007, as much as $15,500 to a 401(k) ($20,500 if you're 50 or older) or up to $4,000 to an IRA ($5,000 if you're 50 or older). Those contributions reduce your taxable income, and that in turn reduces your tax bill.

Roth plans don't allow pretax contributions, but you'll never have to pay taxes on the accounts' investment earnings. That benefit can make a Roth IRA or Roth 401(k) a good choice for young investors or for workers who expect to be in a higher tax bracket in retirement.

Better yet, most companies match a portion of your 401(k) contribution -- the nearest thing to a free lunch in the investment world.

Tax-Efficient Investments

When investing through taxable brokerage accounts, keep in mind that some investments generate higher tax bills than others. For example, mutual funds that have high turnover rates often throw off more taxable gains in a particular year than funds that keep turnover low.

A recent Charles Schwab(SCH) study found that investors in high tax brackets who held assets in taxable accounts over a 20-year period lost an average of 2.4% of their total returns to taxes.

You may be able to boost after-tax returns by using tax-managed funds, which pursue low-turnover strategies, harvest losses to offset taxable gains and use other methods to cut investors' tax burdens. Vanguard, Fidelity and Putnam, among others, offer tax-managed funds.

Municipal bond funds also can boost after-tax income for high-tax-bracket investors. While they tend to offer lower yields than taxable bonds, munis' exemption from federal taxes -- and in some cases from state and local taxes -- may allow them to offer better returns in taxable accounts.

Taxes are only one consideration when determining your investment strategy--but they're an important one. "The old saw holds true," says Shapiro. "Taxes are inevitable. But high taxes aren't."

Coming up next: Increase Your Returns