The Beauty of Tax-Deferred Investing
Taxable investments require that you pay taxes on annual interest or dividends and on any profit on investments you sell. For instance, if you have a savings account, you'll be taxed on the interest it earns. Tax-deferred investments, on the other hand, offer you a way to avoid paying taxes on your current earnings, at least until you reach a certain age or meet other qualifications. This chapter discusses the different types of tax-deferred investments and how you can best take advantage of them.
A tax-exempt (or tax-free) investment is one where current income earned on the investment is not taxed — for instance, most municipal bonds. Keep in mind that even tax-exempt investments aren't necessarily free of all taxes. Depending on the investment, you may be exempt only from certain taxes, like federal income tax or state and local taxes.
When you hold investments outside special tax-deferred accounts, you will likely be required to pay taxes on their earnings, both regular income (like interest and dividends) and capital gains. Virtually every type of investment is taxable on some level, from stocks to bonds to funds. Even real estate investments, businesses you own a piece of, and collectibles, basically, any investment you make where you can enjoy the profits (or suffer the losses) immediately (and not have to wait until some time in the future) can impact your current taxes.
If you have a tax-deferred investment and don't withdraw any money from the account, you don't pay taxes on it. Most of the time, the money you place into tax-deferred accounts will be at least partially, if not completely, tax deductible right now. Of course, some exceptions apply, like Roth IRA contributions or contributions whose deductibility gets phased out based on your income level. Keep in mind that these accounts are meant to be used for large and specific financial goals, like education or retirement. If you withdraw money from these accounts too soon, or use the money for other purposes, you can expect to pay some stiff penalties.
A big plus of tax-deferred investing is the ability to put pre-tax dollars into retirement accounts. For instance, with a 401(k) plan, your contribution to a tax-deferred retirement plan is deducted from your taxable income. This lets you invest money for the future that you would have otherwise paid to Uncle Sam. Let's say your income puts you in the 27 percent marginal income tax bracket, and your annual contribution to your tax-deferred retirement plan is $1,000. Your federal income taxes will drop by $270, or 27 percent of your retirement contribution. Your marginal tax rate (which is the rate you pay on your highest dollar of earnings) determines your savings. To find your marginal tax rate, visit the IRS website at