This is the sixth and final article in the Queercents Investing 101 series. Feel free to browse previous articles in the series.

In the fifth article of this series, we discussed how to turn $10,000 plus $100 a month into $396,368 over 40 years, even after inflation. But that was before we considered the effect of taxes.

I don’t know what tax bracket you’re in, but whatever it is, I know it can seriously hurt the growth of your investments. Let’s see how.

If you are in the 25% federal income tax bracket, and pay 6% in state income taxes, that’s 31% tax each year on your investment earnings. Over 40 years, our nice $396,368 would wind up only $203,421 after those taxes.

If your income tax bracket is 33% federal and 6% state, our $396,368 would only be $173,810 after 40 years taxes.

Beat the Tax Man, Legally

To my knowledge, there are only two ways to legally reduce your taxes on stock market investments: (1) keep your investments in tax-protected savings vehicles and/or (2) hold your investments (each individual purchase) for at least a year.

If you keep your investments in tax-protected vehicles, like a 401(k), a 403(b), or an Individual Retirement Account, you avoid any federal or state taxes on earnings completely, until you begin to withdraw the money. That means you keep the entire $396,368 from our hypothetical example above, and only pay taxes on the small amounts you withdraw each year in retirement.

These particular savings vehicles have the added advantage that you can usually contribute pre-tax dollars, so that saves you money on your taxes now, and money on your investment earnings later. (If you are a single tax filer with an Adjusted Gross Income of $60,000+, your contributions to an traditional IRA are not tax deductible. However, your IRA earnings will still grow tax free until you begin withdrawals).

There are other savings vehicles in which contributions are not tax deductible, but their earnings still grow tax free, for example the 529 College Savings Plan (where earnings are never taxed at all if spent on education costs) and the Roth IRA (but you cannot contribute to a Roth IRA if your Adjusted Gross Income as a single filer is $110,000+).

All of these savings vehicles have contribution limits. For 2007, you can only contribute to your 401(k) up to $15,500 (+$5000 if you are 50 years or older); on top of that, you can also contribute up to $4000 to a traditional or Roth IRA (+$1000 if you are 50 years or older).

Capital Gains

If you don’t have (or have maxed out) a 401(k) and an IRA, you can still avoid paying regular income tax on your stock investments. Just hold on to them for at least a year. Then you will be paying capital gains tax and not income tax on your investment earnings. The capital gains tax is now even less than it used to be, thanks to changes in the tax law the Bush administration pushed through.

What’s the difference with capital gains? If you are currently in the 25% income tax bracket or higher, your capital gains taxes are only 15% on long-term investments (i.e., held more than a year). If you are in a lower tax bracket, your capital gains taxes are only 5%!

However, few people in the lower tax brackets (earning $31,850 as a single filer, or less) have the money to be investing in the stock markets. This capital gains tax is really a major boon to the very wealthy, who are in the top bracket and would otherwise be paying 35% income taxes on their investments. But since the lower capital gains tax exists, you may as well take advantage of it, whatever your tax bracket.

Summing Up

So there it is folks: a few basic guidelines to help you choose investments wisely, keep your costs low, and protect your earnings over time.

Please consider low-cost, no load index mutual funds (not individual stock picking) and plan to hold on to your investments over the long term. This will save you enormously on sales commissions, annual fees, and even taxes.

If you set up automatic investing every month, you can save huge amounts on transaction fees, and it also protects you from buying a lot when prices are very high, or selling at low prices during market panics.

Treat inflation as the enemy, and be careful about putting too much of your hard-earned money into conservative investments like cash savings and bonds: they don’t earn enough over and above inflation to really build your wealth.

Finally, invest all you can into tax-protected savings vehicles like a 401(k) “particularly if your employer matches what you put in! And if you must invest outside of tax-protected vehicles, hold on to your investments long enough to qualify for the capital gains tax rather than ordinary income tax.

Best wishes for a prosperous new year!