In the United States, different investment activities are taxed in different ways. Tax-advantaged investments provide favorable tax treatment for deposits, investment gains or withdrawals, attracting a range of investors looking to reduce their tax obligations. Investors have a number of options available when seeking a tax-advantaged investment, including 401k plans, individual retirement accounts, annuities and Treasury bills. Personal investors should understand the options available to them before deciding how to divide the funds in their portfolio.
A 401(k) plan is a specialized retirement account that individuals can pay into through an employer. Contributions made to 401k accounts are subtracted from individuals' taxable income, reducing tax liabilities during pay-in years. However, investors have to pay taxes on withdrawals made during retirement at their normal income tax rates. This advantage provides an incentive to earn and save more during your working years, essentially spreading your current tax liabilities over your retirement years. A disadvantage to this incentive is that you will be taxed on any gains earned in your account over the years, as well.
Investors can take advantage of a range of tax-deferred IRA options in addition to 401k plans. Traditional IRAs work much like 401k plans, with taxes deferred on contributions. Roth IRAs do not feature the same tax-deferral characteristics as 401k plans, but earnings accrue in Roth IRAs tax-free. This requires investors to pay more taxes during their working years but allows them to receive a larger share of their retirement income in later years, since they do not have to continue to pay taxes on withdrawals. Simplified Employee Pension (SEP) IRAs defer taxes on earnings until the withdrawal period and allow investors to deduct their contributions from their current-year taxable income, providing additional take-home income for savings and investment.
Annuities are specialized debt contracts similar to bonds, although they are often grouped with insurance products in the eyes of the law. Similar to bonds, annuities require an up-front purchase in return for regular payments over a specified term. Unlike bonds, annuities make regular payments of both interest and principal to investors every payment period. Individuals awarded a large lump-sum payment, such as lottery winners or professional athletes, are often paid in annuities to spread their income over a longer period. Taxes are deferred on interest income for annuities, but annuities are taxed at the normal income tax rate when withdrawn, allowing investors to hold on to more of their income during their working years.
Securities issued by the U.S. Treasury offer distinct tax advantages to give investors incentives to lend to the government. Examples of tax-advantaged Treasury securities include T-Bills, Treasury notes and Treasury bonds. Interest on these securities, in addition to Series EE/E and I savings bonds, are exempt from state and local taxes. Federal taxes are deferred until the bonds or notes are repaid in full or sold.
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