Are Tax-Sheltered Investments Right for You?

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Procrastinating is usually a bad thing… but not when it comes to paying taxes.

Here's some good news: Paying taxes is one of the rare times when “putting it off” can actually be a good strategy. If you are making enough to save some money (and everyone should do so, even if it is just a small amount each month), you need to know how taxes will affect your savings over the long run.

Postponing tax payments on your investment returns can make a huge difference over the years. There are a number of (entirely legal) ways to do this. You can also make investments that lower the taxes you owe, along with the pain that goes with paying them.

Here's a look at the best tax-deferred and even tax-free investments you can make today.

Invest Through Tax-Deferred Retirement Accounts

You know that saving for retirement is important if want to live a comfortable life when you stop working. But don't just put money into a taxable savings or brokerage account (or bury it in the backyard). Instead, invest through a traditional IRA and/or employer-sponsored plan such as a 401(k).

This is tax smart for two reasons, no matter what tax bracket you are in right now:

    1. You reduce your taxable income today, thereby lowering your current taxes.
    2. You postpone paying taxes on your investment returns until you withdraw the money, potentially 20 or 30 years (or more) into the future.

Postponing tax payments on your investment earnings allows 100% of that money to stay invested. This kicks the (huge) benefit of compounded returns into high gear.

Using reasonable assumptions about savings rates, tax brackets and after-tax investment returns, we can estimate that someone earning $85,000 per year for the next 25 years would pay roughly 22% less in taxes compared with someone who invests the same amount through a taxable account. And you could end up with 30% more by the end of that period by putting pre-tax money into an IRA or 401(k).

You will have to pay taxes on that money as it comes out of the account when you are retired. But at that point you may be in a lower tax bracket. Even if you're not, postponing tax payments for as many years as possible is a smart move.

A Note About Roth IRAs

Roth IRAs are different. Contributions do not reduce your current taxable income, but withdrawals from a Roth IRA are tax free after you reach age 59½. This includes both your initial investments and 100% of your investment returns. So a Roth IRA allows you to shelter investment income from taxes forever. If you qualify for a Roth IRA, it's a great deal.

Consider an Annuity

If you have contributed the maximum allowed to your 401(k) and IRA and can still save more, you may want to consider an annuity.

In some ways, buying an annuity is like creating your own pension. This is something to think about, since so few employers outside the public sector offer pensions these days.

An annuity generates a series of guaranteed payments beginning on some date in the future (unless you are already retired). Those payments continue either for your entire life or for a specified length of time. You purchase an annuity with a lump sum today, and that money earns a return over time to help fund your future payments.

Those payments can be fixed or can vary depending upon the returns your chosen investments earn. Some annuities offer a combination of a minimum guaranteed payment and a variable portion.

Here's the best part: Just like an IRA or 401(k) plan, you pay no taxes on the earnings from an annuity until your payments begin, sometime after age 59½. (If you pull money out early, withdrawals will be subject to taxes plus a penalty.)

So, annuities allow you to postpone paying taxes on your investment returns while those returns compound over time. Annuities are guaranteed by insurance companies, so choose a strong one.

Invest in Tax-Free Municipal Bonds

Interest earned on bonds issued by a state or local government is usually free from federal income tax. Investors living in some states also don't pay state taxes on their state's bonds. This can be a big deal, particularly for investors who live in states with high personal income tax rates.

A municipal bond usually offers a lower rate of interest than other types of taxable bonds, but the after-tax returns from those bonds can be equivalent or even better. For example, if you earn 4% interest from buying a corporate bond, you might keep less than 3% after taxes. If you earn 3.5% interest from a tax-exempt municipal bond, you keep all of it. Bonds can be among the best tax-free investments out there.

Note that investments in municipal bonds are subject to capital gains taxes. So if you sell a bond at a higher price than you paid, you will owe taxes on the difference. (There are some arcane rules that apply if you bought the bond at a price only slightly below face value. Check with your broker about that.)

Buy Real Estate and Earn Rental Income

When you own real estate, you pay no taxes on the increase in property value until you sell it, which could be many years in the future. If you hold the property for at least a year, any gain when you sell will be taxed at the long-term capital gains rate. This is usually lower than the ordinary income tax rate.

If the property is your primary residence, special tax laws apply at the time of sale if you “roll over” the sale proceeds into a new primary residence.

If you rent out the property, you will owe taxes on the rental income. But you can reduce that taxable income by subtracting expenses incurred to maintain the property, including repairs, property taxes and depreciation.

Limited Partnerships

Partnerships often generate only a small amount of taxable income in the early years as the business is built up. Losses are not uncommon during the partnership's growth. Such partnerships are often used to develop commercial real estate, such as office buildings or hotels. They are sometimes also used to hold oil and gas properties.

You can invest in “limited partnership” units that generate lower income in the near term with the expectation of earning a bigger return in the future, when the property is sold and the partnership is dissolved. At that point, your share of the proceeds is taxed as a capital gain. Since capital gains are usually taxed at a lower rate than ordinary income, this can be a way of “transforming” a portion of investment returns from ordinary income into capital gains.

Some limited partnerships are created expressly to take advantage of tax credits. For example, some government entities offer tax credits to aid with construction of low-income housing. As a limited partner, you can use these tax credits to reduce your taxes directly — dollar for dollar.

A tax deduction reduces taxable income. But a tax credit directly reduces the amount of tax owed. For example, for an investor in the 25% tax bracket, a $100 deduction reduces taxes by $25. But a tax credit of $100 will save him $100 in taxes.

Finally, to reduce the pain you can try to adjust your mindset about paying taxes. It's a tall order, but it does have merit. Remember, the only reason you owe taxes is because you made money, either through working or investing or a combination of the two. That's a good thing.

Larry Ludwig

Larry Ludwig was the founder and editor in chief of Investor Junkie. He graduated from Clemson University with a bachelor of science in computers and a minor in business. Back in the ’90s, I helped create some of the first financial websites for firms like Chase, T. Rowe Price, and ING Bank, and later went on to work for Nomura Securities. He’s had a passion for investing since he was 20 years old and has owned multiple businesses for over 20 years. He currently resides in Long Island, New York, with his wife and three children.

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