NEW YORK (CNN/Money) -
I'm 27 and I took a new job that increased my salary, but doesn't offer a 401(k) or any other retirement plan. I would like to continue funding my Roth IRA, but I can't do that now because my new salary puts me beyond the Roth income qualification limits. I can save about $5,000 a month, but I'm not sure where to put it. What do think are my best options?
-- J.R. Weathers, Watertown, Wisconsin
Well, you may no longer be able to make contributions to your Roth because of your income. But the fact that your current employer doesn't offer any retirement plan means you're probably eligible to contribute to a traditional deductible IRA.
I say "probably" because there could be a limitation if you have a spouse that's covered by a pension plan. To be sure whether you qualify, click here and then click on the "What Kind of IRA is Best For Me?" link.
Assuming you do qualify for a deductible IRA, you can sock away as much as $3,000 this year, an amount that increases to $4,000 in 2005, $5,000 in 2008 and is adjusted annually for inflation in $500 increments thereafter.
The amount you contribute to a traditional IRA is deducted from your taxable income, which provides a pretty decent tax savings. Of course, unlike the case with a Roth IRA, you'll owe taxes at ordinary income rates when you withdraw money at retirement.
If you can really afford to save five thousand bucks a month, however, then an IRA is going to soak up only a small portion of your available savings. Which leads to the question, what to do with the rest?
The key is to avoid paying as much in taxes as possible, and the new tax bill provides ample opportunity. Most important, it has lowered the maximum tax on long-term capital gains and dividends to 15 percent.
One way to take advantage of the new provisions of the bill is to find stocks that have solid long-term growth prospects and hold them for the long-term. As long as you hold a stock longer than a year, then any gain is taxed at the lower long-term capital gains rate. And by holding longer than a year, you not only pay the lower rate, but you postpone paying any tax at all until you sell. In effect, you create your own tax deferral.
If you're not up for buying individual securities, then you can concentrate on stock mutual funds that keep more highly taxed short-term capital gains distributions to a minimum. You might also consider tax-efficient funds, a breed of funds that actively attempts to keep taxable distributions to a minimum through a variety of techniques, including taking losses in some securities to offset gains in others.
Go for dividends
Given the new low tax rate on dividends, you'll also want to consider adding some dividend-paying stocks to your portfolio. Remember, though, while dividends are taxed at the same rate as long-term capital gains, they're not quite as attractive in a tax sense. That's because dividends are typically distributed quarterly, which means your dividend payments get taxed every year.
You don't pay the tax on long-term capital gains, however, until you sell the security (or, in the case of mutual funds, until your manager sells).
To the extent you do short-term trading in stocks or own funds that do so, you'll probably want to hold those securities in a tax-advantaged account such as your Roth or traditional IRA account. That way, the gains will be sheltered from the tax man (permanently in the case of the Roth, until withdrawal in the case of the traditional IRA).
The same goes for other investments that generate income taxed at ordinary income rates, such as taxable bonds. Conversely, you should first look to put dividend-paying stocks and funds that generate long-term capital gains into taxable accounts in order to take advantage of the lower tax rates on dividends and capital gains.
Finally, keep in mind, that there's a difference between being mindful of taxes when investing and getting obsessed about them. Your starting point for building a portfolio should always be to create a mix of stocks, bonds and cash that makes sense given your risk tolerance and financial goals.
After all, what good is exploiting every last provision of the tax code if you end up with a portfolio that's dangerously overweighted in some areas and underweighted in others -- and that may need to be revised anyway the next time Congress re-writes the tax laws.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged."