Tax-Favored Investments

Knowing the tax laws or hiring someone who knows the tax laws to help you with your tax planning each year is your best defense when it comes to lowering your tax liability.

Keeping good records is a must, because you always want to be able to back up any deduction you take on your tax return.

You can pay your taxes now, you can defer them, or perhaps no taxed will ever be due, depending on the investments you choose. We pay current taxed on our income or a sales tax on items we buy. Examples of tax-free investments include tax-free municipal bonds, the new Roth IRA, the educational IRA, and EE Savings bonds when used to pay for a college education.

In a tax-deferred investment, you can put off paying the taxes to some time in the future. Examples of tax-deferred investments would be retirement plans (both employer sponsored and for the self-employed) as well as EE savings bonds, new prepaid 529 college savings plans, and annuities. You will owe taxes when you begin to withdraw the money.

 

Another subtle form of tax deferral is when you hold onto an investment and it appreciates over time, such as with a stock. You don't owe taxes on that asset until you actually sell it, and if you hold it for longer than a year, it will be taxed at the capital gains rate.

Deferring taxes when possible is always a good tax strategy. The first place to look for tax-deferral opportunities is where you work. What does your employer provide? A 401(k) plan, a 403(b), a 457, the Federal Thrift Savings Plan, or a SIMPLE-IRA.

Contributing to your retirement plan at work using pretax dollars is a great way to reduce your current tax liability. Here, you get your cake and can eat it, too. The income earned on investments you have made with pretax dollars compounds tax deferred until you begin to withdraw the money in retirement, and then and only then will you owe income taxes on the money.

If your marginal tax bracket is 28 percent, for every dollar you contribute to your plan, it actually is costing you only 72 cents. Such a bargain! If you want to invest that same dollar in an after-tax investment, you would need to actually start with $1.39 because you would have to pay the 28 percent tax first before you have the dollar in your hand to invest.