Make Tax Efficiency a Part of Your Investment Strategy
When reviewing investment options, many people focus strictly on returns. But it’s critical to also consider tax efficiency as you build a portfolio.
There are two types of investment accounts: tax-advantaged and taxable. Tax-advantaged accounts are any investment or savings option that’s either tax-exempt, tax-deferred or offers some other kind of tax benefit. When you take advantage of tax-advantaged investing, you can reduce the impact when Uncle Sam comes calling on April 15th.
One of the most common and well-known tax-advantaged accounts is the 401(k). Many employers offer a 401(k) as part of their workplace benefits. There are two main types:
- A traditional 401(k)grows tax-deferred. You contribute money from your paycheck before taxes are taken out, lowering your taxable income today. You save money on taxes now, but you pay taxes on your withdrawals later. If you think you’ll be in a lower bracket during retirement, this can be one way to realize tax savings over time.
- A Roth 401(k)grows tax-free. You make your contributions with after-tax dollars. So, even though you pay taxes today, you don’t have to pay taxes when you withdraw during retirement. If you think your taxes will be higher in the future, this can be a good move, reducing your tax liability during retirement.
HSA (Health Savings Account) – The “Triple Tax Advantage”
If you have a high-deductible health plan and meet other requirements, you might be able to contribute to an HSA. With this type of account, you get what’s often called a triple tax advantage:
- Contributions are made with pre-tax dollars, resulting in tax savings today.
- Money in the HSA grows tax-deferred, allowing it to accumulate without the drawback of paying taxes as you accrue earnings from investments.
- Withdrawals aren’t taxed if they’re used for qualified medical expenses.
Some retirees use an HSA in conjunction with other tax-advantaged investing accounts. For example, an HSA can pay for health costs during retirement, while money from the 401(k) is used toward everyday expenses.
529 Savings Plans
After you’ve shored up your own finances, you might want to use a tax-advantaged account to save for your kids’ education. Many states offer 529 savings plans that can help you do just that, whether you’re putting money away for college or even K-12 tuition. Both prepaid tuition and savings plans are available but investment options and fees may differ by state. Contributions are made with after-tax dollars, but money in the account grows tax-free if withdrawals are used for eligible education expenses.
Understand Your Options
Taxes can have a big impact on your financial picture and can sometimes be complicated to fully understand. Nonetheless, it’s important to consider tax-advantaged investing when establishing your personal financial plan. If you have questions, reach out to us about which tax-advantaged investment options might be best for you.