Investing is one part of building wealth, and another is reducing or avoiding taxes. The best investments offer great returns and tax benefits. Although some investments bring high returns, taxes significantly reduce their profits.
Tax-advantaged investments allow you to get 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 earn.
To save you money, Benzinga has explored which investments offer the best tax advantages.
The best tax-efficient investments
Tax-advantaged investments defer your taxes, exempt them, or provide other tax advantages. 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 upon withdrawal.
One of the tax advantages you can benefit from is an investment that allows you to reduce your taxable income. Another advantage is that you are 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 company-sponsored retirement savings plan. Employees who invest in a 401(k) contribute a percentage of their paycheck to the account, and employers match part or all of the contribution.
Employees can choose between two types of 401(k) – traditional or Roth. A traditional 401(k) deducts an employee’s contributions from gross income. Contributions are before tax.
Employees do not pay taxes on contributions or earnings. Taxes are only due 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 this Roth account are not taxed even when you withdraw them, providing a significant tax advantage. If certain rules and holding periods are followed, no tax is due when you make withdrawals from a Roth 401(k).
Traditional and Roth 401(k) employee contributions are limited. In 2022, the total annual contribution to a 401(k) by an employee cannot exceed $20,500, excluding employer contributions. Employees over 50 can add an additional $6,500 as a catch-up contribution.
Withdrawals without penalty are made from the age of 59 and a half. Usually, a withdrawal before this age will result in a 10% penalty. You must start making withdrawals at age 72.
403(b) or 457 plans
Two retirement plans similar to a 401(k) are 403(b) and 457(b). Both plans are tax-deferred retirement savings programs offered by employers such as nonprofits, public educational institutions, and churches. Some employers offer both plans and allow employees to contribute to both. The 457(b) plan is specifically for employees of government and certain nonprofit organizations.
Both plans offer pre-tax contributions from your paycheck. Your contributions and earnings are not taxed until you withdraw them.
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 age 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 included compensation or the carry-forward limit of $20,500 per year. This plan does not have 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 allows employees to make contributions before or after tax. Your investment is tax-deferred and the IRS does not tax capital gains or dividends until withdrawn.
Income limits for investing in a traditional IRA do not exist, but they do apply to tax-deductible contributions. In 2022, your total annual contributions to traditional and Roth IRAs cannot exceed $6,000 ($7,000 if you are 50 or older).
Your withdrawals must begin at age 72. You can withdraw from the age of 59.5 without penalty of 10% for early withdrawal.
A traditional IRA allows you to withdraw qualified tuition without an early distribution penalty. However, the distribution is taxable. The same goes for withdrawing $10,000 from an IRA for your first home purchase.
Contributions to a Roth IRA are not tax deductible. Qualified distributions are tax exempt if you meet certain conditions. A balance can stay in the Roth IRA for the rest of your life. Required minimum distributions do not apply.
A Roth IRA allows people age 70.5 and over to make contributions. This is especially beneficial if you think your marginal taxes will be higher than they are now. You must make contributions to the IRA in cash, not securities or real estate. For 2022, your annual contribution to traditional and Roth IRAs cannot exceed $6,000 ($7,000 if you are 50 or older).
A 529 plan offers tax advantages and helps you save for tuition. Two types of 529 plans exist – prepaid tuition plans and college savings plans. You can use your 529 savings to fund college education, student loan repayments, K-12 tuition, and even apprenticeship programs.
Contributions to the 529 plan are after-tax and your earnings are tax-exempt.
You have the option of withdrawing contributions for eligible education expenses, which are tax exempt. Withdrawing ineligible education expenses results in income tax and a 10% penalty. There is no penalty for leaving funds in a 529 plan after graduating or leaving college.
A Health Savings Account (HSA) allows you to save pre-tax money for eligible 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 the HSA are not subject to federal income tax and earnings are tax exempt. Distributions are tax-free if you spend them on eligible medical expenses. Spending the funds on ineligible medical expenses exposes you to taxes and a 20% penalty.
Why choose tax-efficient investments?
Investing is risky and expensive. Your goal as an investor is to reduce both downsides to maximize income. Investing in tax-advantaged accounts benefits you in several ways.
To save money
Some investments can generate high income, but the taxes paid on them can significantly reduce your profits. Tax-efficient investments offer benefits that help you invest more money by not taxing contributions or ensuring your withdrawals are tax-free.
Some investors are unaware of the taxes applicable to investments. They may not be aware of capital gains tax or early withdrawal penalties. Some investors think investment income is earnings, so they’re shocked to find that taxes have affected their bottom line.
With tax-efficient assets, investors’ income is not taxed. Tax-exempt investments do not include any taxes.
Long term success
Holding an investment for a long time helps you reduce or eliminate taxes. The benefit of receiving tax-free contributions means you can invest more, and more money invested generally translates into a higher return.
Choosing a tax-efficient 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-efficient investments don’t guarantee returns, and investment mistakes can shrink your portfolio. You should be aware of all costs associated with managing your account and applicable taxes. Consult a professional to determine which account is best suited to your needs.
Not knowing the tax rules of the account: Some investments are tax exempt. Not all tax-advantaged accounts are tax-exempt, so you need to know what is taxable and when. Find out what the tax rules are for early withdrawals and qualifying expenses. Knowing the taxes will help you choose the right account to maximize your returns.
Not realizing the full potential of the account: You need to know as much as possible about a potential investment account. Missing a key detail could result in not using its full potential. You should know how to use your account rules to your advantage. A consultant can advise you on different strategies that will help you grow the account.
Choosing the wrong accounts: One of the ways investors pick the wrong account is by not knowing their goals; another is not knowing what they are investing in. You should establish your retirement goals and find an account that is most likely to achieve those goals.
The wrong account can reduce your expected returns. Additionally, picking the wrong stocks can sink your portfolio to zero.
Open too many accounts: Some investors want to minimize risk by opening multiple accounts. This can 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 them all for a long time, or they forget some accounts.
To get the most out of a tax-efficient investment, you need to choose the right broker. Benzinga explored the market and compared the best brokers.
Frequently Asked Questions
What is the most tax-efficient investment?
What is the most tax-efficient 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?
Which investments are best for taxable accounts?
The best investments for taxable accounts are stocks and equity funds. Municipal bonds are also a good option because they generate tax-free income.