9. Investing Tax Strategies
Another way to maximize the potential for long-term portfolio growth through compounding is by taking advantage of tax-deferred and tax-free investment accounts.
When you invest through a traditional tax-deferred account, including individual retirement accounts (IRAs) and employer-sponsored plans, such as 401(k)s, you don’t owe income tax until you begin making withdrawals from the account, generally after you retire. Because you don’t have to pay taxes on your earnings every year, your investment compounds untaxed, significantly boosting its growth potential. In many cases, you can defer taxes on your contributions to these accounts as well, helping your account to compound even faster.
You may reap even more tax advantages with a tax-free retirement or education account, such as a Roth IRA or Roth 401(k) (if your employer offers this alternative), or a 529 college savings plan or Coverdell education savings account (ESA). As with tax-deferred accounts, you owe no tax on current income or capital gains on realized profits. In addition, your withdrawals are federally tax-free—and may be exempt from state and local income tax as well, depending on the type of account—provided you follow the rules for withdrawals.
One major consideration is the types of investments to emphasize in each type of account. For instance, you should think carefully before including any investments in a tax-deferred account that are already tax-exempt, such as municipal bonds or bond funds that invest in munis. That’s because you won’t receive any additional tax benefit and you’ll owe taxes at your regular rate on any interest earnings at withdrawal, even though that interest would have been tax exempt had you held the investments in a taxable account.
You may also want to evaluate whether to purchase annuities in your IRA since annuities are already tax deferred. In addition, the annual expenses on deferred annuities are typically higher than on mutual funds that make similar investments.
If you have bonds or other fixed-income investments, apart from municipal bonds or municipal bond funds, it’s best to put them in tax-deferred or tax-free accounts. Tax-deferred and tax-free accounts are also well-suited for growth investments, such as stock and stock funds, which may benefit most from the potential for long-term compounding. Although you will have to pay tax on your withdrawals at your regular income tax rate rather than the long-term capital gains rate, you probably anticipate that your income tax rate will lower after you retire. While many people do fall into a lower income tax bracket in retirement, be aware that this isn’t always the case.
Taxable Investment Accounts
While you may want to invest as much as you can—up to the annual limits— in tax-deferred and tax-free accounts, there are also reasons to invest in taxable accounts. Taxable investment accounts can work especially well if you’re a buy-and-hold investor because you owe no income tax on price appreciation until you sell the investment. If you’ve held the investment for more than a year, you owe tax on any gains at the long-term capital gains rate, which is significantly lower than your income tax rate.
While you will owe taxes on dividends and mutual fund distributions, they may also be taxable at the low long-term capital gains rate if you’ve held the investments for the required amount of time and they qualify for this tax treatment, which stock in most U.S. corporations and a number that are based overseas do.
Interest you earn on bonds and cash equivalents, such as certificates of deposit (CDs) are taxable as income. But you may be able to minimize the tax bite by choosing municipal bonds or municipal bond funds for income. The interest they pay is exempt from federal taxes and may also be exempt from state and local taxes if the bonds are issued by your home state. There are two potential downsides. Municipal bond interest may be subject to the alternative minimum tax (AMT), so you’ll want to discuss the potential implications with your tax or investment professional. In addition, municipal bonds usually pay interest at a lower rate than other bonds because of their attractive tax status.
When choosing funds for a taxable portfolio, you might want to consider funds with low portfolio turnover, which pay out fewer short-term capital gains. Index funds and exchange traded funds (ETFs) are usually tax efficient since they buy and sell investments only when there’s a change in the index they track. Some actively managed funds also emphasize tax efficiency as an investment objective.
One potential benefit of having some of your assets in taxable accounts is that you generally can sell your investments and spend the money without any penalty or red tape. That’s not the case if all of your investments are in IRAs and employer-sponsored plans, which can make it difficult to get access to your money if you need it in an emergency.
Here’s a summary of the appealing features and some of the potential limitations of three ways to save for retirement. One strategy is to use all of the types you qualify for, so that you can benefit from the advantages that each of them offers.
| Taxable Account | Tax-Deferred Account:Traditional deductible IRA
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Tax-Free Account: Roth IRA | |
| Pros |
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59 1/2 and your account has been open at least 5 years
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| Cons |
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