3 Tax-Efficient Investment Types
Investing is an excellent method to increase your money over time. However, one disadvantage is that you must routinely pay taxes on your investment earnings. And, of course, the more taxes you pay, the less of your earnings you get to retain. As a result, knowing the best strategies to reduce your taxes and keep more of your money working for you is essential. Here are some of the investment types to keep your investment income taxed as low as possible.
Municipal bonds
Municipal bonds are bonds issued by local governments that are utilized to support various undertakings such as road improvements or school construction. When you invest in a municipal bond, you are essentially lending money to the government. The advantage to you is that you will receive a guaranteed rate of return from the bond in the form of interest payments. Individual municipal bonds or municipal bond funds (mutual funds or ETFs) that carry a diverse portfolio of munis can be purchased. Dividends paid by a fund are derived from the interest generated on its bonds, thus they are tax-free for investors. Some municipal bond interest is subject to the Alternative Minimum Tax (AMT). However, there is very little chance of default, and the potential to earn steady income in your portfolio tax-free makes them an excellent addition to a fixed-income portfolio.
529 College savings plan
Paying for college can be a significant financial burden, and tuition rise continues to outstrip inflation. However, 529 savings accounts might make it easier to prepare for it. Investment returns grow tax-free in 529 accounts, and withdrawals are tax-free as long as the money is spent for any qualified educational expense. Almost every state has at least one 529 college savings plan, and you can contribute to any of them regardless of where you live. The payments you make will not qualify for a federal tax deduction, while deductible contributions are permitted in a few states. If you open one when your child is young, you will benefit from tax savings and also get compounding interest.
Roth IRAs and Roth 401(k)s
The earnings you earn in a Roth IRA are never taxed. Therefore, this is perhaps the best option to permanently decrease your tax burden. Even while you pay tax on the money you put into a Roth, the possibility of receiving tax-free returns on that money over time is unrivaled. However, the benefit comes when you reach the age of 59½, but keep in mind that a Roth IRA must be in place for at least five years before you can begin taking tax-free withdrawals from your Roth IRA.
Most employers will match your 401(k) plan contributions up to a certain level. Because your contributions are made before taxes, they reduce your taxable income for the year. And your employer’s contribution is essentially free money. If you are self-employed, though, you can enroll in a single Roth 401(k). You invest after-tax dollars, and eligible withdrawals in retirement are tax-free. The main distinction between a Roth 401(k) and a Roth IRA is that you must begin taking minimum distributions from a Roth 401(k) at the age of 70½.
