Tax-advantaged investments can help you maximize your returns. Simply put, a tax-advantaged investment is any type of investment, account, or savings plan that offers notable tax benefits to the investor. These investments allow you to minimize the amount of taxes you pay, either by deferring, reducing, or, in some cases, completely avoiding them. You may want to work with a financial advisor who can help with your own tax planning.
Understanding Tax-Advantaged Investing
Essentially, tax-advantaged investing involves various types of investments, accounts and savings plans that provide tax benefits such as tax deductions, tax deferrals and tax-free income. These tax benefits can significantly enhance the total return on an investment as you don’t have to pay as large of a tax bill, reducing that return. Let’s make this more relatable in order to fully grasp this concept.
Suppose you’re investing for retirement. You opt for a tax-advantaged account, and over the years, thanks to the tax breaks, more of your money stays in the account. This enables your savings not only to grow faster but also ensures that you have a larger retirement fund than you would without those tax benefits. And remember, despite the math involved, understanding the fundamental principle of tax advantages isn’t as complicated or daunting as it seems.
Different Types of Tax Advantages in Investing
As an investor, you should know about three key types of tax advantages.
First, there are tax-exempt investments, which aren’t subject to taxes. Examples of these can include municipal bonds and certain types of mutual funds.
Second, there are tax-deferred investments, which let you put off paying taxes till a later date. Traditional individual retirement accounts (IRAs) and 401(k) plans are typical examples of this kind.
And third, there are tax-deductible investments, which decrease your taxable income. Contributions to certain retirement accounts like a traditional IRA or a 401(k) can be tax-deductible.
How Tax-Advantaged Accounts Work
Tax-advantaged accounts, such as 401(k)s or IRAs, give investors certain tax benefits. All of these provide some type of tax advantage. You either can contribute to these accounts before paying tax, or you can withdraw without paying tax. But these benefit-laden accounts come attached with specific conditions like:
- Limits on how much you can contribute
- Penalties for early withdrawal
For instance, a traditional IRA lets you make pre-tax contributions, effectively lowering your taxable income for the year. The investments in the account mature tax-deferred, which means you won’t shell out taxes on the gains until you make withdrawals during retirement. While there are limitations on the benefits you receive, they still provide a significant benefit. The longer you use these accounts, traditionally, the more benefits you’ll end up receiving.
How Individual Tax-Advantaged Investments Work
Aside from tax-advantaged accounts, there are individual tax-advantaged investments such as municipal bonds, select mutual funds and treasury securities. The benefits are going to vary by investment but traditionally allow you to either withdraw tax-free or make a deduction when you have a return.
As an example, consider municipal bonds. The interest earned is usually exempt from federal taxes and may also be free from state and local taxes if you’re a resident of the state where the bond issuer is based.
Take note: These tax benefits may vary, and non-residents may not enjoy the same advantages. These characteristics make municipal bonds especially attractive for people in higher tax brackets.
Bottom Line
Tax-advantaged investments can help reduce your tax liability. By understanding the different ways in which these tax advantages work, you can make informed decisions for your portfolio.
Tips for Tax Planning
- A financial advisor is possibly best equipped to help you plan out your tax consequences and help protect against potential tax consequences of investing. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re wanting to estimate your potential tax benefits, consider using SmartAsset’s free income tax calculator.
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