Investing is one part of building wealth, and another is reducing or avoiding taxes. The best investments offer great returns and tax advantages. Although some investments yield high returns, taxes significantly reduce their profits. Tax-advantaged investments enable you to earn good returns, and their tax advantages allow you to keep more money. After all, investing is about how much you keep, not how much you make. To save you money, Benzinga explores the best tax-advantaged investments.
Quick Look at the Best Tax-Advantaged Investments:
The Best Tax-Advantaged Investments
Investments offering tax advantages defer your taxes, exempt them or provide other tax benefits. Tax-exempt investments are the most beneficial because you never have to pay tax on them. Tax-deferred investments require you to pay taxes later, usually on the withdrawal.
One of the tax benefits you may receive is an investment that enables you to reduce your taxable income. Another benefit is being taxed on your income when you withdraw the investment and not on the income you made during the contribution phase, which could be higher.
A 401(k) is a retirement savings plan that is company-sponsored. Employees investing in a 401(k) contribute a percentage of their paycheck to the account, and employers match a portion or the total contribution.
Employees can choose between two types of 401(k)s — traditional or Roth. A traditional 401(k) deducts an employee’s contributions from gross income. Contributions are pre-tax.
Employees don’t pay taxes on contributions or earnings. Taxes are due only on withdrawals, which most people make in retirement.
A Roth 401(k) allows the employee to contribute after-tax earnings from wages; the investment dollars you earn over time in that Roth account are not taxed even when you withdraw them, providing an important tax benefit. If certain rules and holding periods are met, no taxes are due when you make withdrawals from a Roth 401(k).
Employee contributions traditional and Roth 401(k)s are limited. In 2022, the total annual contribution to a 401(k) by an employee cannot exceed $20,500, excluding employer contributions. Employees older than 50 can add an extra $6,500 as a catch-up contribution.
Penalty-free withdrawals are from age 59 ½. Usually, withdrawing before that age will result in a 10% penalty. You have to start making withdrawals from age 72.
403(b) or 457 Plans
Two retirement plans similar to a 401(k) are the 403(b) and 457(b). Both plans are tax-deferred retirement savings programs that employers such as non-profits, public educational institutions and churches offer. Some employers offer both plans and enable employee contributions to both. The 457(b) plan is specifically for government and certain non-profit organization employees.
Both plans offer pre-tax contributions from your paycheck. Your contributions and earnings aren’t taxed until you withdraw.
Contribution limits for 403(b) and 457(b) plans vary. In 2022, the annual contribution limit for a 403(b) by employees is $20,500; however, employer contributions are limited to $61,000. Employees aged 50 or older can take advantage of catch-up contributions, allowing $6,500 above the standard limit.
For a 457(b) plan, annual contributions and other additions cannot exceed the lesser of 100% of an employee’s includible compensation or the deferral limit of $20,500 annually. This plan lacks a separate employer contribution limit.
An individual retirement account (IRA) allows contributions to be fully or partially deductible, depending on your income and filing status. An IRA enables employees to make pre-tax or after-tax contributions. Your investment is tax-deferred, and the IRS doesn’t tax capital gains or dividends until withdrawal.
Income limits for investing in a traditional IRA don’t exist, but they apply for tax-deductible contributions. In 2022, your total annual contributions to traditional and Roth IRAs cannot exceed $6,000 ($7,000 if you’re 50 years or older).
Your withdrawals must start at age 72. You can withdraw from age 59 ½ without 10% penalties for premature withdrawal.
A traditional IRA enables you to withdraw for qualified college expenses without an early-distribution penalty. However, the distribution is taxable. The same applies to withdrawing $10,000 from an IRA for your first home purchase.
Contributions to a Roth IRA aren’t tax-deductible. Qualified distributions are tax-free if you meet certain requirements. A balance can remain in the Roth IRA for the remainder of your life. Required minimum distributions are inapplicable.
A Roth IRA allows people 70 ½ and older to make contributions. It’s mostly beneficial if you believe that your marginal taxes will be higher than currently are. You have to make IRA contributions in cash, not in any security or real estate. For 2022, your annual contribution to traditional and Roth IRAs cannot exceed $6,000 ($7,000 if you’re age 50 or older).
A 529 plan offers tax benefits and helps you save for educational costs. Two types of 529 plans exist — prepaid tuition plans and education savings plans. You can use your 529 savings to fund college, student loan repayments, K-12 tuition and even apprenticeship programs.
Contributions to the 529 plan are post-tax, and your earnings are tax-free.
You have the flexibility for withdrawing contributions for qualified educational expenses, which are tax-free. Withdrawing non-qualified educational expenses results in taxes on the earnings and a 10% penalty. No penalty is applicable for leaving funds in a 529 plan after graduating or leaving college.
A health savings account (HSA) enables you to save pre-tax dollars for qualified medical expenses. You can use untaxed dollars in HSA to fund copayments, deductibles and coinsurance, but you can’t use them to pay premiums.
Contributions to HSA aren’t subject to federal income taxes, and earnings are tax-free. Distributions are tax-free if you spend them on qualified medical expenses. Spending the funds on non-qualified medical expenses exposes you to taxes and a 20% penalty.
Why Choose Tax-Advantaged Investments?
Investing is risky and costly. Your aim as an investor is to reduce both disadvantages to optimize earnings. Investing in tax-advantaged accounts benefits you in several ways.
Some investments may provide high earnings, but taxes paid on them can significantly reduce your profit. Tax-advantaged investments offer benefits that help you invest more money by not taxing contributions or ensuring your withdrawals are tax-free.
Some investors aren’t familiar with taxes applicable to investments. They might not know about capital gains tax or early-withdrawal penalties. Some investors believe that investment earnings equate to profits, so they’re shocked to discover that taxes have affected their bottom line.
With tax-advantaged assets, investor earnings aren’t taxed. Tax-exempt investments don’t include any taxes.
Holding an investment for a long period helps you reduce taxes or nullify them. The benefit of receiving tax-free contributions means that you can invest more, and more money invested usually results in a higher return.
Opting for a tax-advantaged investment means you can choose a plan that taxes your contributions, allowing you to enjoy tax-free withdrawals in retirement.
Mistakes to Avoid With Tax-Advantaged Accounts
Tax-advantaged investments don’t guarantee returns, and investment mistakes can reduce your portfolio. You should know all the costs involved to manage your account and applicable taxes. Consult a professional to determine the account most suitable for your needs.
Not knowing the tax rules for the account: Certain investments are tax-exempt. Not all tax-advantaged accounts are tax-free, so you need to know what’s taxable and when. Find out what the tax rules are regarding early withdrawals and qualified expenses. Knowing the taxes will help you choose the right account to maximize your returns.
Not realizing the account’s full potential: You should know as much as possible about a potential investment account. Missing one key detail could result in not utilizing its full potential. You must know how to use your account’s rules to your advantage. A consultant can advise you about different strategies that help you grow the account.
Choosing the wrong accounts: One of the ways investors choose the wrong account is by not knowing their goals; another is by not knowing what they’re investing in. You should establish your retirement goals and find an account that’s most likely to achieve those objectives.
The wrong account can reduce your expected returns. Also, picking the wrong securities can plunge your portfolio to zero.
Opening too many accounts: Some investors wish to minimize risk by opening several accounts. That may work if you have enough money to fund all the accounts and good administration skills.
The problem with having too many accounts is that some investors are overwhelmed. They can’t fund all of them for a long period, or they forget about some accounts.
Getting the most out of a tax-advantaged investment involves choosing the right broker. Benzinga explored the market and compared the best brokers.
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Frequently Asked Questions
What is the most tax-advantaged investment?
Tax-exempt investments are the most advantageous. Investments such as 401(k) and IRAs provide tax-free contributions or withdrawals.
Which investments are best for taxable accounts?
The best investments for taxable accounts are stock and stock funds. Municipal bonds are also a good option because they generate tax-free income.
Which tax-advantaged investments does Benzinga recommend?
Check out the above article for Benzinga’s list of the best tax-advantaged investments.