Tax-advantaged Accounts and Investments

ax season is right around the corner. As we begin preparing our taxes, we may be wondering why we’re paying so much to Uncle Sam. Good news, there’s a number of ways to legally and ethically reduce your tax bill. Here are the most common tax-advantaged accounts and investments that can help reduce your tax bill.

Traditional IRAs

The Traditional Individual Retirement Account (IRA) is a tax-advantaged retirement savings account. Contributions to the account are not taxed when you invest them, meaning you can write off contributions from your gross income, effectively lowering your taxable income for the year. Your money can then grow tax free until you withdraw it.

When you withdraw your money, the withdrawal will be considered taxable income by the IRS and you will pay tax when you file taxes for that year. If you withdraw before you reach the age of 59½, you’ll have to pay a 10% penalty unless you qualify for an IRS exception, such as a disability, unreimbursed medical expense, or first-time home purchase. Bottom line, only invest in a Traditional IRA if you plan to withdraw after you’re 59½.

A Traditional IRA allows you to invest in stocks, bonds, CDs, ETFs, and various other assets. It’s a great way to grow your savings tax free and prepare for retirement. On the other hand, investing in a Traditional IRA ties up your money until you’re 59½ unless you’re willing to pay the 10% penalty or qualify for an IRS exception. In addition, if you expect to be in a high tax bracket when you withdraw your money, you may end up with a hefty tax bill.

Roth IRAs

Similar to the Traditional IRA, the Roth IRA is primarily used to save for retirement and offers diverse investment options. On the contrary, Roth IRA contributions are taxed when you contribute and are not taxed when you withdraw. Earnings in your Roth IRA are not taxed if you’re 59½ and have been contributing to the account for 5 years.

This is great for younger investors just starting out in their careers because they will likely be in a lower tax bracket now compared to when they retire. So it makes sense to pay lower taxes now and forgo paying higher taxes later. Another advantage of the Roth IRA over the Traditional IRA is there is no 10% penalty for early withdrawals of contributions (you’ll still be taxed on earnings and pay a 10% penalty on them).

401(k) Plans

Many employers offer the option to contribute to a 401(k) Plan with matching contributions from the employer. These plans also come with tax benefits in the form of a Traditional 401(k) and Roth 401(k). Tax rules and investment options for these two types of 401(k)s are almost identical to the Traditional IRA and Roth IRA explained above.

The advantage of a 401(k) over an IRA is the employer match. Oftentimes, employers match 100% of your contributions up to a certain percentage of your pay. I don’t know about you, but I think a 100% return on investment is pretty good.

529 Plans

529 Plans are tax-advantaged savings accounts for higher education expenses. After-tax contributions are made to the plan and the earnings on those contributions are tax free when used to pay for higher education. In addition, the account is transferable, meaning you can change the beneficiary when you please.

Don’t have kids yet but are planning on it? You can start a 529 Plan in your name now and transfer it to your child’s name when he/she is born. And if you don’t end up having kids, you can transfer it to your niece, your friend, or whoever you please.

HSAs

Health Savings Accounts (HSAs) are tax-advantaged savings accounts for medical expenses. If you’re enrolled in a high-deductible insurance plan then an HSA is for you. The tax advantage is that you may contribute pre-tax dollars into the account and withdraw funds to pay for unreimbursed medical expenses. Another perk is that some HSAs will allow you to invest your contributions in mutual funds or ETFs.

Municipal Bonds

A municipal bond is a fixed-income security issued by a state, county, or local government to fund schools, highways, public buildings, etc. Municipal bonds typically pay interest to bondholders and that interest is exempt from federal income tax. Returns are influenced by a number of factors, including interest rates, inflation, maturity, and credit risk.

Investment Real Estate

There are quite a few tax advantages to investing in real estate. First, an owner of a rental property can write off depreciation expense (paper losses) against rental income earned. Oftentimes, the depreciation expense is significant enough to offset your rental income, meaning the rental income is tax free.

Second, when you sell real estate, you can defer capital gains tax by executing a 1031 Exchange, which is a tax loophole that allows you to exchange your old real estate asset for a new one, thus, deferring a hefty tax bill.

Third, passive income earned from rental properties avoids the FICA (payroll) tax, which is a 7.65% tax on your salary. If you’re self-employed your FICA tax is 15.3%. Rental income is preferable to salary, wages, or business income because it avoids the FICA tax.

Fourth, capital gains tax rates (the tax you’ll pay on an appreciated sale) are lower than ordinary income (salary, wages, commissions, tips, business income) tax rates. Capital gains rates are anywhere from 0-20% compared to tax rates on ordinary income from 10-37%.

Lastly, there are a number of other tax benefits to investing in real estate, including cash out refinancing, live-in flips, installment sales, and self-directed IRAs for real estate investing.

Wrapping it Up

Tax-advantaged accounts and investments are important for investors to maximize returns. Determine your wealth goals and select the tax-advantaged accounts and investments that make the most sense for you.