What is the Best Tax Efficient Investing Account?

What is the best tax efficient investing accounts?

One of the first things I learned when I started studying to be a financial advisor over 20 years ago was the effect of taxes on investments. However, most people totally forget about taxes when it comes to maximizing returns and rather think thinking about asset allocation and investment strategy. If you consider account taxes, holding costs, and commissions your savings may have, you may start to look through alternatives. One of the most costly expenses in investments is taxes.

How expensive can taxes be? Imagine you invest $1000 for 30 years and invest $1000 every year afterward. After 30 years you would have $84,802 (fully -taxable account), 100,259 (tax-deferred) or $70,761 (tax-free).

Summary Fully-Taxable Tax-Deferred Tax-Free
Current investment balance $1,000 $1,000 $1,000
Annual contributions $1,000 $1,000 $1,000
Number of years to invest 30 30 30
Before-tax return 8% 8% 5%
Marginal tax bracket 25% 25% 25%
After-tax return 6% 8% 5%
Future account value * $84,802 $123,346 $70,761
Future account value (after-tax) $84,802 $100,259 $70,761

After seeing the above chart, you might be thinking that “tax-deferred investing” is the right way to go, the short answer is maybe. Unfortunately, you may not qualify for a tax-deferred account or Congress could change the rules.  Biden has proposed eliminating the 100% write off for tax-deferred investing and replacing it with a graded down.  If you are in a higher tax bracket or where you pay state income taxes, then you may need to consider other options as well.  The best way to find out the right type of tax account is to sit down with a CPA that fully understands your current and future tax situation.

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So, what types of accounts are the best tax-efficient investing? The short answer is Roth IRA, Traditional IRA, 401k, 529 Account, Municipal Bonds, MLPs, and Health Savings Accounts.  With all these options, it can be a bit overwhelming. Don’t worry, we will do our best in this article to help you get a basic understanding of each of the tax-efficient accounts.

Let’s take a closer look at some of the options, which will help you decrease the tax burden.

Invest through Roth IRA

The only time you will have to pay taxes on Roth IRA is when you first put money in it. Whenever you want to withdraw your finances from this account, they are 100% tax-free! Investing in a Roth IRA is, by far, one of the most common ways to permanently reduce your tax burden.

One may argue that in the case of higher investment Roth IRA is not an optimal solution as the up-front payment of tax is considerably higher. That’s true, however, note that you also can earn tax-free returns compounded for many years. So, sooner or later, you will have to payback on your upfront tax payment.

Contribute to 401(k) plan

A growing number of employers offer Roth 401(k) plans to their employees, which allows them to contribute up to $19,000. With the 401(k) plan, employees have an opportunity to set aside part of their salary before federal and state income taxes are withheld. For example, one gets a $30,000 salary with a tax bracket of 25%. If you contribute 6% of your salary ($1,800) to the 401(k) plan, it means your taxable income becomes $28,200.

So, not only do you take advantage of saving for retirement, but you also avoid paying too much in taxes.

Traditional IRA

Traditional IRA is similar to a 401(k) contribution plan but without matching employer contribution. Like a 401(k) plan, a traditional IRA reduces your taxable income, but you have to pay taxes whenever you withdraw your investment (no sooner than the age of 59.5, no later than 70.5).

With an IRA, you have unlimited flexibility in your investment options, which is excellent for those who are comfortable directing their finances. If you max out your 401(k) contribution plan limit,  Traditional IRA can allow you to save more.

A 529 Account

If you or your children plan to apply for college and save on future expenses, open a 529 account. Start saving as soon as you can by creating an account for each of your children. Investment returns accumulate tax-free in this account as long as the finances are directed to educational purposes.

Some states offer tax deductions invested in a state’s 529 plan. Even if you think it is too early to think of your child’s college expenses, starting sooner will help you gain higher returns.

Health Savings Account (HSA)

Similar to IRA, HSA is used to pay for qualified medical purposes. The amount you put in HSA is tax-deductible, lowering your tax bill at the end of the year.

Moreover, when you withdraw from a Health Savings Account, you don’t have to pay taxes as long as it is used for qualified medical purposes. Money on this account continues to earn interest as long as you don’t use it; however, finances are entirely under your control.

U.S. Series I Bonds

Similar to the 529 plan, Series I can be used for higher educational purposes. The difference between Series I Bonds and 529 accounts is that you can only buy $10,000 per Social Security number.

You won’t have to pay taxes on interest income if you use them for tuition or fees, including lab courses, the cost of books and materials of your university program, and other education-related expenses.

MLPs and Municipal Bonds

An attractive investment method for those in the highest tax brackets, tax-exempt municipal bonds can be a great way to save more. These bonds are exempt from federal tax and state tax (depending on which state you live in and which bonds you buy). Municipal bonds offer lower interest rates than most taxable bonds but allow you to keep most or all of the interest you earn.

If you can’t choose between the millions of municipal options, you will need a broker to identify which bonds meet your needs. Another method to broaden your portfolio is by investing in MLPs. MLPs are publicly traded and combine tax benefits of limited partnerships while offering liquidity of publicly traded security

Being tax-aware of your investment activities will help you have higher returns and save more for the future. All of the investment methods mentioned above are a great way to diversify your portfolio and maximize returns. The most critical thing for an investor is to identify needs and evaluate which method is best for them.

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