Taxes can take a big bite out of your total investment returns, so it’s helpful to look for tax-advantaged strategies when building a portfolio. But keep in mind that investment decisions shouldn’t be driven solely by tax considerations; other factors to consider include the potential risk, the expected rate of return, and the quality of the investment.
Tax-deferred and tax-free investments
Tax deferral is the process of delaying (but not necessarily eliminating) until a future year the payment of income taxes on income you earn in the current year. For example, the money you put into your traditional 401(k) retirement account isn’t taxed until you withdraw it, which might be 30 or 40 years down the road!
Tax deferral can be beneficial because:
• The money you would have spent on taxes remains invested
• You may be in a lower tax bracket when you make withdrawals from your accounts (for example, when you’re retired)
• You can accumulate more dollars in your accounts due to compounding.
Compounding means that your earnings become part of your underlying investment, and they in turn earn interest. In the early years of an investment, the benefit of compounding may not be that significant. But as the years go by, the long-term boost to your total return can be dramatic.
Taxes make a big difference
Let’s assume two people have $5,000 to invest every year for a period of 30 years. One person invests in a tax-free account like a Roth 401(k) that earns 6% per year, and the other person invests in a taxable account that also earns 6% each year. Assuming a tax rate of 28%, in 30 years the tax-free account will be worth $395,291, while the taxable account will be worth $295,896. That’s a difference of $99,395.
Tax-advantaged savings vehicles for retirement
One of the best ways to accumulate funds for retirement or any other investment objective is to use tax-advantaged (i.e., tax-deferred or tax-free) savings vehicles when appropriate.
• Traditional IRAs — Anyone under age 70½ who earns income or is married to someone with earned income can contribute to an IRA. Depending upon your income and whether you’re covered by an employer-sponsored retirement plan, you may or may not be able to deduct your contributions to a traditional IRA, but your contributions always grow tax deferred. However, you’ll owe income taxes when you make a withdrawal.* You can contribute up to $5,500 (for 2016 and 2017) to an IRA, and individuals age 50 and older can contribute an additional $1,000 (for 2016 and 2017).
• Roth IRAs — Roth IRAs are open only to individuals with incomes below certain limits. Your contributions are made with after-tax dollars but will grow tax deferred, and qualified distributions will be tax free when you withdraw them. The amount you can contribute is the same as for traditional IRAs. Total combined contributions to Roth and traditional IRAs can’t exceed $5,500 (for 2016 and 2017) for individuals under age 50.
• SIMPLE IRAs and SIMPLE 401(k)s — These plans are generally associated with small businesses. As with traditional IRAs, your contributions grow tax deferred, but you’ll owe income taxes when you make a withdrawal.* You can contribute up to $12,500 (for 2016 and 2017) to one of these plans; individuals age 50 and older can contribute an additional $3,000 (for 2016 and 2017). (SIMPLE 401(k) plans can also allow Roth contributions.)
• Employer-sponsored plans (401(k)s, 403(b)s, 457 plans) — Contributions to these types of plans grow tax deferred, but you’ll owe income taxes when you make a withdrawal.* You can contribute up to $18,000 (for 2016 and 2017) to one of these plans; individuals age 50 and older can contribute an additional $6,000 (for 2016 and 2017). Employers can generally allow employees to make after-tax Roth contributions, in which case qualifying distributions will be tax free.
• Annuities — You pay money to an annuity issuer (an insurance company), and the issuer promises to pay principal and earnings back to you or your named beneficiary in the future (you’ll be subject to fees and expenses that you’ll need to understand and consider). Most annuities have surrender charges that are assessed if the contract owner surrenders the annuity. Annuities generally allow you to elect to receive an income stream for life (subject to the financial strength and claims-paying ability of the issuer). There’s no limit to how much you can invest, and your contributions grow tax deferred. However, you’ll owe income taxes on the earnings when you start receiving distributions.*
Tax-advantaged savings vehicles for college
For college, tax-advantaged savings vehicles include:
• 529 plans — College savings plans and prepaid tuition plans let you set aside money for college that will grow tax deferred and be tax free at withdrawal at the federal level if the funds are used for qualified education expenses. These plans are open to anyone regardless of income level. Contribution limits are high–typically over $300,000–but vary by plan.
• Coverdell education savings accounts — Coverdell accounts are open only to individuals with incomes below certain limits, but if you qualify, you can contribute up to $2,000 per year, per beneficiary. Your contributions will grow tax deferred and be tax free at withdrawal at the federal level if the funds are used for qualified education expenses.
• Series EE bonds — The interest earned on Series EE savings bonds grows tax deferred. But if you meet income limits (and a few other requirements) at the time you redeem the bonds for college, the interest will be free from federal income tax too (it’s always exempt from state tax.)
Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans. More information about specific 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing consider whether your state offers a 529 plan that provides residents with favorable state tax benefits. The availability of tax and other benefits may be conditioned on meeting certain requirements. There is also the risk that the investments may lose money or not perform well enough to cover college costs as anticipated. For withdrawals not used for qualified higher-education expenses, earnings may be subject to taxation as ordinary income and possibly a 10% federal income tax penalty.
The information contained in this document is for educational and informational purposes only. It does not consider your particular investment objectives or financial situation and does not make personalized recommendations. It is not intended to provide specific legal, investment, accounting, tax, or other professional advice. The information is obtained from sources believed to be reliable but its accuracy and completeness is not guaranteed. Individuals should consult with the appropriate professionals to help answer questions about their specific situations or needs prior to taking any action based on this information. This material is not intended to replace the advice of a qualified tax professional. Before making any financial commitment, consult with your tax adviser. Please consult your tax professional regarding your particular situation.