Advantages of Tax-Free Investments
Tax-free investment accounts have several advantages. For one, there aren’t any minimum required distributions, so you can deposit funds according to your financial goals. Once you meet certain requirements, your distributions will also be tax-free. Because you’re paying taxes upfront when you contribute to your account, there’s no penalty to withdraw your contributions. Furthermore, tax-free accounts come with multiple penalty exemptions, allowing you to withdraw your contributions, as well as accumulated investment earnings, depending on the type of account.
For instance, tax-free plans, such as a Roth IRA, aren’t taxable as long as you’ve had the account for at least five years. Because the money you contribute to your Roth IRA is subject to immediate income tax, you won’t owe any additional taxes on funds you withdraw. Tax-free accounts can also help lower your taxable income, avoiding any effect on other retirement benefits you receive. Another advantage of tax-free plans is that you can pay taxes upfront on contributions you make at a lower rate, ultimately saving money long-term.
Benefits of Tax-Deferred Investments
Tax-deferred investment instruments offer many benefits, including the ability to put off paying taxes until you take distributions from your account. In addition, the contributions you make each year may qualify for tax deductions, giving you more ways to save money immediately and when you start withdrawing from your retirement account. Unlike tax-free options, tax-deferred investment plans don’t have any income limits, so you won’t need to worry about falling into a different income bracket that could otherwise affect how much you pay in taxes when you withdraw.
Depending on the type of tax-deferred account, you can opt to have your contributions withheld from your paycheck before taxes or deduct them when you file income taxes. Since contributions are pre-tax, they can reduce your taxable income. This means lower tax liability for the year you’re filing in. For example, a tax-deferred annuity allows you to accumulate earnings and interest pre-tax, reducing your taxable income for the year you file.
Strategic Considerations for Tax Planning
While both tax-deferred and tax-free options have advantages, it’s important to understand how these two approaches to tax planning can affect your future savings. Depending on your income bracket, a mix of tax-deferred and tax-free investments can be an efficient approach to allocating retirement funds and maximizing savings — both pre- and post-tax. Here are several considerations when it comes to tax planning and maximizing savings:
Create a diverse portfolio of taxable and tax-exempt accounts. For example, if you have a 401(k) through your employer, you may opt for a tax-deferred annuity to supplement your savings and reduce the taxes you’ll owe when you withdraw in retirement.
Protect against the unknown. With a diverse mix of taxable and tax-exempt accounts, you can better protect against any uncertainty regarding your tax bracket once in retirement. For instance, you may be able to minimize your overall tax liability by taking tax-free municipal bond earnings and long-term capital gains from taxable accounts and tax-free income from a Roth IRA.
Consider charitable giving and estate planning. Maximize short- and long-term savings with charitable giving and estate planning. For instance, you could give appreciated securities from a taxable account to a non-profit organization and deduct this contribution to avoid capital gains tax later.
Potential Pitfalls and Misunderstandings With Tax-Free vs. Tax-Deferred Accounts
Contrary to popular belief, tax-deferred doesn’t always mean you’ll save on taxes. Similarly, being tax-free doesn’t mean being free from taxes altogether. A common misconception about tax-deferred investment accounts is that they allow you to defer taxes to a later date. While this is, in essence, what many instruments let you do, you can defer too much and end up with hefty taxes when you withdraw income from your account during retirement.
In addition, you can be subject to a penalty for early withdrawal from your retirement accounts, so it’s important to understand which assets are best allocated to tax-deferred and tax-free options. Contact the team at Anderson Advisors for more insights into the right investment and retirement planning options for you.