Make the Most of Your Money With Tax-Advantaged Accounts

Understanding the different ways investment vehicles are treated from a tax standpoint isn't always easy. Terms like "tax-deferred" and "tax-deductible" can be confused or misunderstood given the financial jargon that peppers almost any financial literature. But knowing how certain retirement savings tools are taxed can go a long way in helping you build a tax-efficient investment strategy. After all, whatever you save in taxes can be allocated toward funding your financial goals.

Keep reading to learn what the different tax classifications mean and how you can grow your money as tax-efficiently as possible.

Tax-Deductible Retirement Assets

Retirement assets are considered tax-deductible when contributions can be deducted from taxable income when calculating income tax due. What this does is reduce your taxable income, saving you from having to pay higher taxes today.

For example, if your gross paycheck is $4,000, and you put $400 of that into your 401(k) plan before taxes are applied, the $400 is tax-deductible, which means you are taxed as if you only earned $3,600. If your income is taxed at a 24% rate, you would have owed $960 in tax on the entire $4,000. However, since you contributed $400 you only pay taxes of $864 (a savings of $96 or 24% of $400).

Tax-Deferred Retirement Assets

Tax-deferred refers to being able to postpone paying taxes on the growth on your retirement assets until you start taking distributions. Depending on how you invest, your money grows through compounding interest, capital gains and/or dividends. But rather than having to pay taxes on your portfolio’s growth when it occurs, tax-deferred means you’ll simply pay taxes later.

For example, using the previous situation, the $400 invested in your 401(k) is now growing tax-deferred. You will pay no tax on the money until you take it out of the account (you can start taking these funds at 59.5 and must start taking them at 70.5). When you do finally take it out, the funds will be treated as taxable income.

Tax-Free Retirement Assets

Tax-free means exactly that, the funds are never taxed.

For example, if you live in New York and purchase certain types of New York municipal bonds, the interest payments you receive may be tax-free, meaning you pay no state or federal taxes on the income. (For related reading, see: Earn Tax-Free Income.)

Roth IRA Account

A Roth IRA is one of the most tax-advantaged ways to save toward retirement. Unlike a traditional IRA, a Roth IRA is funded with after-tax dollars, grows tax-free and can be withdrawn tax-free.

Roth IRAs were created by Delaware Senator William Roth to incentivize people to save more for retirement. The incentive to invest in a Roth IRA is so appealing there are strict income limits on who can invest in a Roth IRA and how much can be contributed annually:

• If you are single, your modified adjusted gross income (MAGI) must be under $135,000 to contribute to a Roth IRA for the 2018 tax year, and contributions are reduced starting at $120,000.
• If you are married filing jointly, your MAGI must be less than $199,000, with reductions beginning at $189,000.
• If you are under 50, you may contribute up to $5,500 in 2018. If you are 50 or over, you may contribute $6,500.

Health Savings Account

One financial tool has the greatest tax benefit of all. The contributions you make into it are tax-deductible, your money grows tax-free, and withdrawals are tax-free. This triple tax benefit is a quality unique to a health savings account (HSA).

Health savings accounts allow people with high-deductible health plans to invest money that they can then use for current healthcare costs and save toward future healthcare needs. As long as you use the money on qualified medical costs, you get all three tax benefits. (For related reading, see: Pros and Cons of a Health Savings Account.)

The Bottom Line

Having a mix of investment vehicles that are taxed differently is helpful in retirement when you need to operate on a fixed income. Your traditional 401(k) or IRA will likely be your primary income, but remember you pay taxes with every distribution. When you have a large expense, like taking a family vacation, you may want to look toward your tax-free Roth IRA funds. And with healthcare costs typically being the highest later in life, having money set aside in an HSA can provide much-needed protection against financial hardship due to an unexpected illness.

Tax-efficient investing isn’t just a good idea, it’s also one of the smartest ways to plan for your long-term needs.

(For more from this author, see: Top 401(k) Mistakes That Hurt Your Retirement Savings.)