What Are Tax-Advantaged Investments?
You’ve most likely heard the term “tax-advantaged” investments. And you may have wondered what kinds of investments fall into this category. Turns out, more than you might imagine. What’s also important to know is that you should explore these options and use them where they make sense.
It’s an obvious statement, but a tax-advantaged investment is any investment that provides a level of tax relief that other, dissimilar investments do not. Using these investment options will allow your money to accumulate more rapidly than otherwise. Following is an overview of selected tax-advantaged investments. It is not meant to be all-encompassing. It excludes real estate investments, which possess distinct tax advantages. The focus here is on the multitude of investment options that may be less familiar than real estate but are no less important and worthwhile.
Municipal bonds: Sometimes referred to as “munis,” these are debt investments issued by federal and state and local governments that generate interest-free dividends. The interest rates they pay are federal tax-free and, if you live in the state where issued, usually tax-free there as well.
Employer-sponsored retirement plans: These are most commonly referred to as 401(k) plans (although similar arrangements exist under different IRS plan codes, such as 403(b) for non-profit organizations and 457(b) plans for governmental workers) and they allow your contributions into the plan to be deducted from your paycheck on a pre-tax basis. If you elect to contribute to a 401(k) plan and defer, for example, $5,000 a year, that amount will be contributed to the plan before any income tax is assessed. If you make $30,000 a year you will only be taxed on $25,000, a substantial tax break. The greater the contribution the greater the savings. On top of this, your investment will grow tax-free until you begin taking distributions. In theory, your tax bracket will be lower in retirement than it is now because you will, by default, be making less money. Being free of any tax during its accumulation, your account balance will grow more quickly than if you lose a certain percentage each year because of taxes.
Traditional IRA (Individual Retirement Account): IRAs are not new at all. They have been around for decades. An IRA is still one of the best tax-advantaged investments available to you. You set up an IRA and then contribute to it with after-tax dollars. Those contributions are usually tax-deductible. For tax year 2019, you may contribute up to $6,000 or $7,000 if you are over age 50. You may invest in a wide array of choices, including mutual funds and fixed-rate CDs. Your investment gains are not taxed until you begin to take distributions, and these distributions have rules connected to them. Withdrawals that take place in violation of these rules will typically be assessed a penalty.
Roth IRA: The Roth IRA has not been around as long as traditional IRA’s, but it offers up significant tax advantages as well. Roth contributions (but not earnings) may be withdrawn at any time. Contribution limits are the same as with an IRA. Contributions to a Roth IRA are not tax-deductible, but accumulations are not taxed. If you hold the account for five years, you may begin to take tax-free distributions (IRAs work just the opposite) because you’ve already paid taxes on the contribution. Even earnings from a Roth are not taxed at distribution. This is truly a distinctive feature, and it represents one compelling reason, among others, why you should ask your advisor about the Roth IRA.
Health Savings Accounts (HSA): If you are enrolled in a high-deductible health insurance plan (HDHP), as defined by the government, you can qualify for an HSA. Many health insurance providers will offer you the opportunity to participate in an HSA. You do so by deciding how much you want to contribute each year. For 2019 the limit is $3,500. Contributions are made on a pre-tax basis and earnings grow tax-free. Each year you may rollover your account balance if you choose, so your contributions will not be “lost” if unused. Investment growth is not taxable. Distributions from an HSA are not taxable after age 65, at which point you can use the asset to help cover Medicare costs.
All these tax-advantaged options are worth a good look. They all offer distinct advantages that will allow you to put your money to the greatest possible use, which is another way of saying that when you are investing for the future you want to shield as much of that investment from taxation as possible. Some may be more suitable than others. You should ask your advisor which options are the best for you.