Sound investing earns you money in two ways. The first is through the returns you receive when your investments increase in value. The second way is through tax savings from investing in instruments that reduce the amount of tax you owe. Investments may be tax-deferred, tax-deductible or both. You pay no tax on tax-deferred investments until you draw out your money. In some cases, you may be allowed to invest pre-tax dollars, according to Nationwide, so you also defer taxes on your contributions. Tax-deductible investments allow you to deduct the amount you invest from your taxable income so you pay tax on less money.
Employee-sponsored 401k plans are both tax-deferred and tax-deductible. You'll save in the short term by deducting the amount you contribute from your taxable earnings. For as long as your money stays in the 401k, you won't pay taxes on it -- not on the principal contributions and not on gains resulting from increases in value. You will, however, be taxed on the money you withdraw after retirement.
Individual Retirement Accounts
Traditional IRAs and Roth IRAs both offer tax advantages. You may be able to deduct your contributions to a traditional IRA account. Taxes are deferred until you start withdrawing money. Roth IRA contributions come from after-tax money, but withdrawals are tax-free once your turn 59-1/2
An annuity is an insurance investment that can provide you with guaranteed retirement income. The tax-deferred varieties grow tax-free until you withdraw money. At that point, the IRS taxes the withdrawals at the same rate as your income. A fixed annuity is the type that provides a guaranteed stream of income after a predetermined number of years, according to Fidelity.com. A variable annuity is riskier because it can lose value, but it has the potential to reap larger gains in value. Your annuity contributions may be tax-deductible if the annuity is part of an employer-sponsored retirement plan.
529 savings plans and Coverdell savings accounts provide tax-advantaged ways to save for college expenses. You'll fund these plans with after-tax income, but the money grows tax-free and withdrawals are tax-free as long as you use them for qualified expenses. You may use educational savings accounts for students up to age 30. Some states allow you to deduct your contributions to 529 savings plans.
Investment Expense Deductions
Your investment-related expenses may be tax deductible even when the investments themselves are not. "Smart Money" lists such costs as investment, accounting and legal fees, investment publications, Internet fees attributable to investment activities and your home office, if that's where you conduct your investing activities. There are limits, however. Costs related to tax-exempt investments are not deductible because you don't pay taxes on the income they generate. And Charles Schwab notes that you may only deduct qualified expenses that amount to more than 2 percent of your adjusted gross income.
- "Smart Money"; Writing off Your Investment Costs; Dec. 2000
- Charles Schwab; Investment Expenses: What's Tax Deductible?; Rande Spiegelman; June 2001
- Nationwide: Talking About Tax-Deferred Investments
- Fidelity: Types of Annuities
- Charles Schwab; Compare Accounts; Understand Your College Savings Options
- "Kiplinger"; 529 Plan FAQs; Cameron Huddleston and Kimberly Lankford; July 2010
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