Taxes can be a serious drag on your investment return and knock your financial plans off track. But there are a number of tax-advantaged ways to invest your money and avoid this downer. These accounts delay or totally avoid income tax on your investment gains, which is win-win for you -- and your bottom line.
Work Retirement Plans
One way to avoid taxes on your investments in by putting money in a work-sponsored plan, like a 401(k). As long as your investments are in a 401(k), you do not owe any tax on the gains. You also get a tax deduction for the money you put into your plan. You only pay tax when you take money out of your plan; when that occurs, you pay tax at your regular rate on the entire withdrawal. In exchange for these benefits, you must keep your savings in your 401k until you turn 59 1/2. If you take money out earlier, you'll get hit with a 10 percent early withdrawal penalty to the IRS.
Individual retirement accounts are another tax-advantaged investment option. There are two types of IRAs: traditional IRAs and Roth IRAs. Both types delay taxes on your investments as long as they stay in the account. When you invest in a traditional IRA, you can deduct your contribution from your taxes. When you take money out in retirement, you'll owe income tax on the full withdrawal. There is no tax deduction on contributions to a Roth IRA. However, you don't owe any income tax when you take money out in retirement. Your gains are tax-free. Like the 401(k), if you need to take money out of a traditional IRA before you turn 59 1/2, you'll have to hand over 10 percent to the IRS as an early withdrawal penalty, except in a very few situations that are deemed exceptions. You may take money you have contributed to a Roth out at any time, but if you withdraw any gains, you will have to pay a penalty and regular taxes if this occurs before the money has been in the account for five years and before age 59 1/2, unless certain exceptions apply.
Life insurance offers an often overlooked tax benefit. If you buy a permanent life insurance policy, one that lasts your entire life, it builds cash value. This is money you can take out while you're alive. Some policies pay a fixed rate of return on your account, while others let you invest your money in the stock market. You can borrow from your cash value and never pay it back. When you die, the loan gets paid out of the life insurance death benefit. Since the IRS does not tax death benefits as income, all your life insurance investment gains are tax-free.
Annuities are another to avoid taxes on your investments. These investments work like a 401(k) or an IRA. When you put money in annuity, it grows tax-free until you take it out. If you need to take the money out before you turn 59 1/2, you owe the IRS a 10 percent early withdrawal penalty. Annuities don't offer any tax advantages besides delaying your investment gains, so you get a better deal putting money in your other retirement plans first. However, there is a limit to the amount you can invest in retirement plans per year. If you want to save more, an annuity offers that option.
David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.