Taxes can take a big bite out of your total investment returns, so it’s helpful to look for tax-advantaged strategies when building a portfolio. Keep in mind that investment decisions shouldn’t be driven solely by tax considerations; other factors to consider include the potential risk, the expected rate of return and the quality of the investment.
Tax-Deferred and Tax-Free Investments
Tax deferral is the process of delaying (but not necessarily eliminating) until a future year the payment of income taxes on income you earn in the current year. For example, the money you put into your traditional 401(k) retirement account isn’t taxed until you withdraw it, which might be 30 or 40 years down the road! Tax deferral can be beneficial because:
• The money you would have spent on taxes remains invested
• You may be in a lower tax bracket when you make withdrawals from your accounts (i.e., during retirement)
• You can accumulate more dollars in your accounts due to compounding
Compounding means that your earnings become part of your underlying investment and they, in turn, earn interest. In the early years of an investment, the benefit of compounding may not be that significant. But as the years go by, the long-term boost to your total return can be dramatic.
Taxes Make a Big Difference
Let’s assume two people have $5,000 to invest every year for a period of 30 years. One person invests in a tax-free account like a Roth 401(k) that earns 6% per year, and the other person invests in a taxable account that also earns 6% each year. Assuming a tax rate of 24%, in 30 years the tax-free account will be worth $395,291, while the taxable account will be worth $308,155. That’s a difference of $87,136. (This hypothetical example is for illustrative purposes only. Actual results will vary.)
Tax-Advantaged Savings Vehicles for Retirement
One of the best ways to accumulate funds for retirement or any other investment objective is to use tax-advantaged (i.e., tax-deferred or tax-free) savings vehicles when appropriate.
• Traditional IRAs — Anyone under age 70½ who earns income or is married to someone with earned income can contribute to an IRA. Depending upon your income and whether you’re covered by an employer-sponsored retirement plan, you may or may not be able to deduct your contributions to a traditional IRA, but your contributions always grow tax deferred. However, you’ll owe income taxes when you make a withdrawal. Note: You can contribute up to $6,000 (for 2019; $5,500 for 2018) to an IRA, and individuals age 50 and older can contribute an additional $1,000 (for 2018 and 2019).
• Roth IRAs — Roth IRAs are open only to individuals with incomes below certain limits. Your contributions are made with after-tax dollars but will grow tax deferred, and qualified distributions will be tax free when you withdraw them. The amount you can contribute is the same as for traditional IRAs. Note: Total combined contributions to Roth and traditional IRAs can’t exceed $6,000 (for 2019; $5,500 for 2018) for individuals under age 50.
• SIMPLE IRAs and SIMPLE 401(k)s — These plans are generally associated with small businesses. As with traditional IRAs, your contributions grow tax deferred, but you’ll owe income taxes when you make a withdrawal. Note: You can contribute up to $13,000 (for 2019; $12,500 for 2018) to one of these plans; individuals age 50 and older can contribute an additional $3,000 (for 2018 and 2019).
• Employer-sponsored plans (401(k)s, 403(b)s, 457 plans) — Contributions to these types of plans grow tax deferred, but you’ll owe income taxes when you make a withdrawal. Note: You can contribute up to $19,000 (for 2019; $18,500 for 2018) to one of these plans; individuals age 50 and older can contribute an additional $6,000 (for 2018 and 2019).
• Annuities — You pay money to an annuity issuer (an insurance company), and the issuer promises to pay principal and earnings back to you or your named beneficiary in the future (you’ll be subject to fees and expenses that you’ll need to understand and consider). Most annuities have surrender charges that are assessed if the contract owner surrenders the annuity. Annuities generally allow you to elect to receive an income stream for life (subject to the financial strength and claims-paying ability of the issuer). There’s no limit to how much you can invest, and your contributions grow tax deferred. Note: However, you’ll owe income taxes on the earnings when you start receiving distributions.
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Kaydan Wealth Management, Inc. does not provide advice on tax or legal issues. These matters should be discussed with the appropriate professional. Kaydan Wealth Management, Inc. is not a registered broker/dealer and is independent of Raymond James Financial Services, Inc. Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc. and Kaydan Wealth Management, Inc.