So you’re ready to start investing for your future, but you’re not sure how it might affect your tax bill. Believe it or not, there are a few clever ways to invest without having Uncle Sam reach even deeper into your pockets. They’re called tax-advantaged accounts and investments, and they are extremely popular with U.S. investors. These special accounts allow you enjoy either tax-deferred or (better yet) tax-free growth of your investments. To top it off, some of these plans offer tax-free distributions.
Whether you’re investing to pay for your child’s future college education or you want to build a nest egg to ensure a comfortable retirement, consider one of these four popular tax-advantaged plans:
Named after a section of the Internal Revenue Code, 401(k)s are defined-contribution plans sponsored by employers as a retirement investment vehicle. If your employer offers a 401(k), you can contribute a certain percentage of your income, which is automatically deducted from your paycheck on a pretax basis. (This means the amount you contribute to your 401(k) is exempt from current federal income tax.) Some employers offer matching contributions to your 401(k) plan, and they may also add a profit-sharing feature to the plan.
The major advantage of the 401(k) is your earnings accrue on a tax-deferred basis. That means the dividends and capital gains earned inside your 401(k) are not subject to taxes until you begin withdrawing from the plan – which will not be, one hopes, until after you retire, when you’ll likely be a lower tax bracket.
The IRS limits the amount you can invest in a 401(k). In 2015, the 401(k) contribution limit is $18,000. There are also restrictions on how and when you can withdraw money from the account. If you withdraw funds from a 401(k) before you reach the retirement age, you’ll probably have to pay penalties. For more, see The Basics Of A 401(k) Retirement Plan.
The Individual Retirement Account (IRA) is another wildly popular tax-advantaged investing tool. The most common types of IRAs are Traditional IRAs and Roth IRAs.
Unlike a 401(k) which is set up by your employer, you (the individual taxpayer) establish a Traditional IRA or Roth IRA. With these accounts, you are allowed to contribute 100% of your compensation up to a set maximum dollar amount. For 2015, the limit on annual contributions to an IRA is $5,500 ($6,500 if you are age 50 or older).
Depending on your income, tax filing status and any additional coverage by an employer-sponsored retirement plan such as a 401(k), your contributions to a Traditional IRA may be tax deductible. To top it off, dividends and capital gains earned inside a Traditional IRA are not subject to tax until withdrawal. Because your income is likely to be lower after retirement, the tax rate on your withdrawals will also be lower. Traditional IRAs also require you to start taking required minimum distributions (RMDs) by April 1 of the year after you reach age 70½.
As with Traditional IRAs, the dividends and capital gains earned inside a Roth IRA accumulate tax-free. However, your contributions to a Roth IRA are not tax deductible. The upside of the Roth is that qualified distributions from this type of account are tax-free and there are no RMDs. For more, see Roth Vs. Traditional IRA: Which Is Right For You?and Take These Simple Steps To Open An IRA.
Known as a “muni” for short, a municipal bond is a debt security issued by a state, municipality or county to finance its capital expenditures. Municipal bonds are often used by a state or city to pay for highways, bridges or schools. When you buy a municipal bond, you are essentially lending money to the issuer in exchange for a specific number of interest payments over a set period. At the end of that period, the bond reaches its maturity date, and the issuer returns the full amount of your original investment to you – unless it is unable to meet its financial obligations. (Bonds are rated from AAA to various types of D ratings based on creditworthiness, with only the top categories considered investment grade.)
If your investment objective is to preserve your capital while generating a tax-free income stream, a municipal bond might do the trick. Thanks to the favorable tax benefits they offer, munis are very popular with people in high income tax brackets. Municipal bonds aren’t only exempt from federal taxes; they are also exempt from most state and local taxes, especially if you live in the state in which the bond is issued.
If you are subject to the alternative minimum tax (AMT), you are required to include interest income from certain munis when calculating the tax. If you fall into this category, consult a tax professional before investing in municipal bonds. For more, see The Basics of Municipal Bonds.
If you’re saving up for your child’s college education, you might want to consider a 529 plan, also known as a “qualified tuition program.” Like the 401(k), the 529 was named after a section of the Internal Revenue Code (another manifestation of IRS creativity…). A 529 plan allows you to prepay for qualified higher education expenses at eligible educational institutions.
Although your contributions to a 529 are not tax deductible, your investment accumulates tax deferred. To top it off, when you use distributions to pay for the beneficiary’s college costs, they are tax-free at the federal level. (In some cases, distributions may also be tax-free at the state level.)
There is no income restriction for individuals who want to contribute to a 529 plan. However, because your contributions cannot exceed the total amount of the beneficiary’s qualified higher education expenses, it’s important not to over-fund a 529 plan. For more, see 529 Risks To Take (Or Not) and 5 Secrets You Didn’t Know About A 529 Plan.