Understanding the different ways investment vehicles are treated from a tax standpoint can be tricky business. Terms like ‘tax-deferred’ and ‘tax-deductible’ can be confused or misunderstood given the gamut of financial jargon that peppers almost any financial literature. But knowing how certain retirement savings tools are taxed can go a long way at helping you build a tax-efficient investment strategy. After all, whatever you save in taxes can be allocated towards funding your financial goals.
Let’s face it, no one likes taxes but, unfortunately, they are a fact of life and here to stay. However, while paying some tax is inevitable, the total amount you pay is not. Here are some simple ways you can understand what the different tax classifications mean and how you can grow your money as tax-efficiently as possible.
Tax-Deductible vs Tax-Deferred vs Tax-Free
First, let’s start by defining these often-confused tax classifications.
Tax-Deductible: Retirement assets are considered tax-deductible when contributions can be deducted from taxable income when calculating income tax due. What this does is reduces your taxable income, saving you from having to pay higher taxes today.
Example: Your gross paycheck is $4,000, and you put $400 of that into your 401(k) before taxes are applied. The $400 is tax deductible which means you are taxed as if you only earned $3,600. If your income is taxed at a 24% rate you would have owed $960 in tax on the entire $4,000. However since you contributed $400 you only pay taxes of $864 (a savings of $96 or 24% of $400).
Tax-Deferred: This refers to being able to postpone paying taxes on the growth on your retirement assets until you start taking distributions. Depending on how you invest, your money grows through compounding interest, capital gains, and/or dividends. But rather than having to pay taxes on your portfolio’s growth at the time the growth occurs, tax-deferred means you’ll simply pay taxes later.
Example: Using the previous example, the $400 invested in your 401(k) is now growing tax-deferred. You will pay no tax on the money until you take it out of the account (you can start taking these funds at 59 ½ and must start taking them at 70 ½). When you do finally take it out, the funds will be treated as taxable income.
Tax-Free: Tax fee means that exactly that, funds aren’t taxed, ever.
Example: If you live in New York and purchase certain types of New York municipal bonds, the interest payments you receive from that bond may be tax-free, meaning you pay no state or federal taxes on the income.
Now let’s look at two accounts that should be part of any tax-efficient investment strategy.
2 of the Best Tax-Efficient Accounts
1. Roth IRA
You don’t have to look far to learn that a Roth IRA is one of the most tax-advantaged ways to save toward retirement. Unlike a Traditional IRA, a Roth IRA is funded with after-tax dollars and then grows tax-free and can be withdrawn tax free.
Roth IRAs were specially created by Delaware Senator William Roth to incentivize people to save more for retirement. The incentive to invest in a Roth IRA is so appealing that there are strict income limits on who can invest in a Roth IRA and how much can be contributed to it annually.
· If you are single, you must have a modified adjusted gross income under $135,000 to contribute to a Roth IRA for the 2018 tax year, but contributions are reduced starting at $120,000.
· If you are married filing jointly, your MAGI must be less than $199,000, with reductions beginning at $189,000.
· If you are under 50, you may contribute up to $5,500 in 2018. If you are 50 or over, you may contribute $6,500.
2. Health Savings Account
There is one financial tool out there that has the greatest tax benefit of all. The contributions you make into it are tax-deductible, your money grows tax-free, and withdrawals are tax-free. This triple tax benefit is a quality unique to Health Savings Accounts (HSA).
Health savings accounts allow people with high-deductible health plans to invest money that they can then use for current healthcare costs and save toward future healthcare needs. As long as you use the money on qualified medical costs, you get all three tax benefits.
Having a mix of investment vehicles that are taxed differently is helpful in retirement so that you can operate successfully on a fixed income. Your traditional 401(k) or IRA will likely be your primary income but remember you pay taxes with every distribution. When you have a large expense, like taking a family vacation, you may want to look toward your tax-free Roth IRA funds that won’t require an associated tax bill to use. And with healthcare costs typically being the highest later in life, having money set aside in an HSA can provide much-needed cover against financial hardship due to an unexpected illness.
Tax-efficient investing isn’t just a good idea; it’s one of the smartest ways to plan for your long-term needs.
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