Minimizing taxes, or avoiding them altogether, plays an important role in many investment decisions. Whether looking at this year's tax burden or thinking far ahead into the future, tax planning is a component of determining an investment mix. While tax avoidance should not drive all of your investment decisions, you need to consider tax consequences.
Tax-Deferred Retirement Accounts
Tax savings is the name of the game when it comes to investing for retirement. Some financial professionals scorn annuities because of their high commissions, but they have remained popular by virtue of the fact that they grow tax-deferred. Investors like to max out their traditional IRAs and employer-sponsored plans, like 401(k)s and 403(b)s, because initial investments are made with pretax dollars. You do not pay taxes today on the money that goes into those accounts. The accounts also grow without taxes, but upon retirement, you pay ordinary income tax on mandatory distributions.
Roth IRA contributions have no immediate tax benefit since your contributions are not tax deductible when you make them. However, Roths have become one of the darlings of the retirement planning world because they grow tax-free, and all distributions are taken free from any taxes. Since just about everyone thinks tax rates will only rise in the future, most savvy investors are stashing away as much as possible into Roths.
One factor that makes real estate potentially profitable is the ability of landlords to deduct all of their property expenses. Rental property losses can be deducted from ordinary income. Each year that you own an income-producing property, you also deduct a percentage of its original cost from income taxes. This annual tax deduction, called depreciation, is a tax benefit that makes owning rentals an appealing investment.
Municipal bonds, issued by state and local governments, are a common tax shelter, popular with investors in high tax brackets. Municipal bonds don't provide a thrill and don't pay high interest rates, but their earnings are federal income tax free. If you buy a municipal bond issued by your own state of residence, it is also state income tax free. Principal values remain steady and defaults are rare, so they are also considered a safe investment. U.S. savings bonds are exempt from state and local taxes, and federal income taxes are deferred until maturity.
Tax Efficient Investments
Some taxable investments are more tax-friendly than others are. In the mutual fund world, index funds and funds with low turnover rates are seen as being comparably tax-friendly since they don't generate a lot of capital gains. Most other mutual funds frequently buy and sell stocks, and their investors may have an unpleasant surprise at tax time when they learn that they owe capital gains taxes on the fund's activity. Exchange-traded funds, or ETFs, are also tax-efficient, since they generally avoid a lot of trades that trigger capital gains.
Life insurance in an investment that not only provides an income for your family in the event of your death, it also protects them from taxes. Life insurance proceeds are not subject to income tax in most cases, so the beneficiary can count on the proceeds without worrying about the tax burden. Roth IRAs are also a good estate-planning vehicle because beneficiaries are not taxed on distributions, as they are with traditional IRAs. However, all retirement accounts are counted as part of an estate for the purposes of determining any estate taxes.
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