Knowing how much you are paying in taxes with regards to your investments can be just as important as your rate of return. By ensuring part of your portfolio is tax-efficient now can help you save when it comes time to retire.
When it comes to your investments—if you’re like most people—you probably focus on the return rates. That’s great, but if you want to keep more of those returns in your pocket rather than Uncle Sam’s, you need to minimize how much you pay in taxes.
One way of doing so is by making tax-efficient investments. Also referred to as tax-advantaged, tax-deferred or tax-exempt, tax-efficient investments include individual retirement accounts (IRAs) and 401(k) plans, both of which give you an upfront tax break by allowing you to deduct your contributions in the tax year in which you make them.
While your annual contributions to these investments are capped—$6,000 to IRAs ($7,000 if you’re 50 or older) and $19,500 to 401(k)s ($26,000 if you’re 50 or older) for 2021—they grow, tax-deferred, until you withdraw them in retirement, at which point you’re likely to be in a lower tax bracket and thus pay less tax.
While advantageous tax-wise, these accounts do have downsides in the form of withdrawal rules and penalties. As a result, you may instead opt for or also have a brokerage or other taxable account that comes with no limits on how much you can invest and that allows you to sell your investments and/or withdraw your money at any time for any reason.
As long as you’ve held the investments for more than a year before selling them, you’ll pay only the long-term capital gains rate1 on any gains you have. That rate ranges from 0 to 20 percent depending on your tax bracket2.
For investments held less than a year, you will pay short-term capital gains. These gains, considered ordinary income, will be taxed at higher rates: from 10 to 37 percent depending on your income.
Two advantages of being tax-efficient
Making your taxable accounts tax-efficient can benefit you in two important ways:
- Advantage #1: No required minimum distributions. Traditional IRAs and 401(k) plans3 require you to begin withdrawing money at age 72. However, with brokerage and other taxable accounts, there is no age at which you must begin to withdraw the money you’ve saved and/or invested; that money can remain invested—and potentially increase in value—indefinitely.
- Advantage #2: Potential tax savings for your beneficiaries. When your beneficiaries eventually sell the investments they inherit from you, they will be taxed on their value at the time of your death, not at the price you paid when you purchased them. This means you not only avoid paying capital gains on the growth of these investments, so too will your beneficiaries. This can be an especially big advantage if the value of the investments has increased significantly over time.
Annuities are tax-efficient, too
One additional way to be tax-efficient with your investments is via annuities. Annuities are long-term, tax-deferred vehicles designed especially for retirement. Although deposits into annuities are not tax-deductible, the interest you earn is tax-deferred; you won’t have to pay taxes on it until you begin making withdrawals.*
That’s good news as this tax-deferral period can have a dramatic effect on the accumulation and withdrawal amounts of your investments. Use this calculator to see how.
There are three main types of annuities, each of which can provide tax-deferred growth:
- Fixed annuities preserve your principal because your money is not invested in the market. Instead, fixed annuities pay you a guaranteed fixed interest rate that adds interest to your account the entire time you own the annuity. What’s more, fixed annuities take advantage of the power of tax-deferral: you keep more of what you earn, giving you more money that can continue to grow in value.
- Fixed index annuities are long-term, tax-deferred vehicles also designed especially for retirement. They combine the advantages of fixed annuities with the opportunity to participate in a portion of the growth that may be realized by a market index such as the S&P 500 or the Dow Jones Industrial Average.†
- Variable annuities allow you to spread your wealth across a wide range of investment options which may help grow your assets, tax-deferred. However, unlike fixed and fixed index annuities, variable annuities involve investment risk and may lose value.
So, whether you are growing your assets in preparation for retirement or to leave a legacy for those you love, it’s important to explore the many tax-efficient investments available to you, including annuities. To learn more about the potential benefits of annuities, start your journey here.