Boost Your Income: Lower Your Tax Bill

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

>To order reprints of this article, click here: Reprints