Tax-Efficient Investing

by Michael Dreiser

Investors in the United States may utilize a number of tax strategies to maximize investment returns. The Internal Revenue Code contains multiple provisions, both in the form of deferred or reduced taxation and specialized tax rates, that encourage taxpayers to invest and save for retirement.

Individual Retirement Accounts

The Internal Revenue Code allows taxpayers to contribute to a number of tax-beneficial individual retirement accounts (IRAs), allowing the taxpayer to reduce federal income taxes in the year the taxpayer contributes to the IRA. Among the most common of these accounts are a 401k (an employer-sponsored plan named after the section of the Internal Revenue Code creating it), a traditional IRA, and a Simplified Employee Pension (SEP) for small-business owners and the self-employed. These plans allow the taxpayer to reduce taxable income for federal income tax purposes by the amount contributed to the plan. In addition, amounts contributed to the plan grow tax-deferred until the taxpayer distributes the funds. Each plan has an annual contribution maximum set by the Internal Revenue Code, which differs from plan to plan and from year to year.

Roth IRA

A Roth IRA is another tax-beneficial individual retirement account, although the form of tax benefit varies significantly from other IRAs. While taxpayers receive a tax benefit at the time of contribution to most IRAs, taxpayers contributing to a Roth IRA receive no tax benefit at contribution and invest in the Roth IRA with after-tax dollars.The tax benefit of a Roth IRA comes in that investments in a Roth IRA grow tax-free. When traditional IRAs are distributed, the investor pays tax on the full value of the distribution. No tax is due on qualified distributions from a Roth IRA.

Choosing Between IRA Plans

For most taxpayers, because of the substantial tax benefit from contributions to these plans, it is beneficial to make investments to an IRA before making other, taxable investments. Taxpayers with a choice between a Roth IRA and a traditional IRA or 401k must consider their current tax rates and their expected tax rates at the time of distribution. In general, when the taxpayer expects his current tax rate is higher than his expected tax rate at the time of distribution, a traditional IRA or 401k may be the preferential investment vehicle. On the contrary, when a taxpayer expects his tax rate at the time of distribution to be greater than his current tax rate, a Roth IRA may be the best vehicle.

Deferred Taxes Through Capital Investments

Taxpayers not investing through an IRA may both reduce and defer taxes by investing in capital assets. Tax on most capital assets is not due until the capital assets are sold or disposed of. Therefore, taxpayers with capital assets that have appreciated in value can generally defer the recognition of the gain simply by not selling the asset. Taxpayers may wish to sell other investments without capital appreciation (such as certificates of deposit or money market funds) prior to the sale of appreciated capital assets. In addition, most capital assets (including stocks) that have been held for more than one year qualify for special, reduced capital gains tax rates. These rates are significantly less than rates paid on other forms of investment income, such as interest -- which is taxed at full, ordinary income rates.

About the Author

Michael Dreiser started writing professionally in 2010. He is a certified public accountant with experience working for a large New York City accountancy and expertise in areas ranging from private equity taxation to investment management. He holds a Master of Business Administration in international finance from l’École Nationale des Ponts et Chaussées in Paris.