Which Investment Types Are the Most Tax-Efficient?

Everyone who enjoys paying taxes, raise your hand…

Hmmm, no hands.

Now, if you prefer having money to not having it, raise your hand. Yup, lots of hands in the air.

Alas, having money and paying taxes tend to go… well… hand in hand. No one likes paying taxes, but not paying them tends to lead to very big problems, from an IRS audit to possible imprisonment. It’s not recommended.

What you can do is postpone paying taxes or reduce what you owe. There are a number of perfectly legal ways to do this. Ranked from most to least tax efficient in the following order, they are:

1. Roth IRA (if you qualify)
2. Employer-sponsored 401(k) plan with matching contributions
3. Traditional IRA (if you don’t have an employer and do not qualify for #1)
4. A 529 account (if you plan to pay college education expenses)
5. Health savings account (HSA)
6. U.S. Series I Savings Bonds
7. MLPs and municipal bonds

Also important in reducing taxes is the concept of asset location. Broadly speaking, this means choosing which accounts should hold each type of investment, based on whether the account is tax deferred or not. Investments that generate a lot of income (usually in the form of interest and/or dividends) are better off in your IRA or 401(k). You can keep things that do not generate much taxable income, like most exchange traded funds (ETFs) and some mutual funds, in a taxable investment account. Note that “actively managed” funds can generate a hefty tax bill.

So with that said, let’s talk about legal ways to postpone or reduce your taxes.

1. Invest Through a Roth IRA

This is probably the best way to permanently reduce your tax burden, because the returns you earn in a Roth IRA are never taxed. Never! 100% of your withdrawals from a Roth IRA are tax free. Even though you pay tax up front on the money that goes into a Roth, the ability to earn tax-free returns on that money, compounded for many years, is unbeatable. The maximum you can contribute to a Roth IRA for 2019 is $6,000, so it’s not a huge amount of money, but year after year, it adds up.

Some people will argue, “But I have to pay tax up front on the money I invest in a Roth IRA. Contributing to a traditional IRA or 401(k) lowers my taxable income, so it reduces my tax today.” True, but that’s like saying you’d rather buy a nice dinner tonight than enjoy years and years of feasting after you retire.

With a traditional IRA, you avoid paying a relatively small amount in tax when you put money into the account, but you pay tax on all of the money, including years and years of investment returns, when it comes out. Unless you’re only a couple of years away from retiring, the Roth is the better deal. You can begin withdrawals after age 59½, but note that a Roth IRA must be in place for at least five years before you can take withdrawals, regardless of your age.

There are income limitations for contributing to a Roth IRA. If you are single, your modified adjusted gross income (MAGI) must be under $137,000 for 2019, and contributions are reduced starting at $122,000. If you are married filing jointly, your MAGI must be less than $203,000, with reductions beginning at $193,000. If you exceed the limit, there is a legal “backdoor” way to convert a regular IRA to a Roth IRA that you may want to consider.

2. Contribute to an Employer-sponsored 401(k)/403(b) Plan

Most employers will match your contributions to a 401(k) or 403(b) plan, up to a specified amount. Your contributions are pre-tax, so they lower your taxable income for the year. And your employer’s contribution is free money. You pay tax on 100% of the withdrawals, which you can begin at age 59½.

A growing number of employers now offer a Roth 401(k), which is similar to a Roth IRA but allows you to contribute up to $19,000. If you’re 50 or above, that increases to $25,000. Obviously, this is much more than the $6,000 limit for a Roth IRA. The limit applies to your total 401(k) contributions, whether to a traditional 401(k), a Roth 401(k), or both. Employer matching contributions always go into a regular (non-Roth) 401(k) account.

One downside to these employer-sponsored plans is that you are limited to the investment options the plan offers. Most offer low-fee index funds, but watch out for any that have high fees, and be sure to diversify. If your plan offers limited choices of only high-fee funds, you may want to invest only up to the amount that earns you the highest matching contribution from your employer.

3. Contribute to a Traditional IRA

A traditional IRA is similar to a 401(k)/403(b) but without a matching employer contribution. Your contributions reduce your taxable income the year they are made, but you pay tax on that money and on your investment returns when you take withdrawals (no sooner than age 59½, no later than age 70½). Still, postponing those tax payments for 10, 20 or possibly 30+ years before you take withdrawals is a big benefit.

With an IRA, you have virtually unlimited flexibility in your investment options, which can be good or bad, depending upon how comfortable you are with directing your own investing. You may want to seek advice on that.

If you max out your 401(k) contributions and still want to save more, you can contribute to a traditional IRA, but not pre-tax. So, keep careful records to avoid paying tax on that money again when you take withdrawals from the account.

4. Save for College With 529 Plans

If you have children and plan to pay for some or all of their college expenses, or if you plan to pursue a degree for yourself in the future, open a 529 plan. Open an account for each child (even if they’re not born yet!) and start saving as soon as you can, even if it is only a small amount per month. Investment returns accumulate tax free in 529 accounts, and as long as the money is used for any qualified educational expenses (not just tuition), withdrawals are tax free. Some states even offer a tax deduction for money invested in that state’s 529 plan.

If you are a grandparent, aunt, uncle or other caring individual who wants to help pay for a child’s college education, it is usually better for you to contribute money to the account owned by the child’s parent than establish a separate account that you own. We won’t go into details, but it affects financial aid eligibility.

Most financial advisors recommend you save for retirement before putting money aside for a child’s education. You can’t borrow to pay for your retirement, and a child has many more years to earn money to repay a student loan than you have to save for your retirement. But not everyone agrees with this perspective.

5. Pay Medical Expenses With a Health Savings Account

A health savings account (HSA) allows you to get a tax deduction for medical expenses with the benefit of tax-efficient investing. It’s almost like an IRA linked to a high-deductible health plan. Instead of saving for retirement, the account is used to pay for present qualified medical expenses.

The amount you put into the account is tax deductible, which lowers your tax bill at the end of the year. Any interest earned on the funds is tax deferred, and withdrawals are not taxed as long as the money is spent on approved medical expenses. Unlike a traditional flexible spending account (FSA), the funds in an HSA are not use-it-or-lose-it.

Money in the account continues to earn interest until you use it for medical expenses, and the funds are completely under your control. This is a great option for people who choose high-deductible health plans.

Once your HSA reaches a certain dollar amount (usually $2,000 or more), you can open an HSA Investment Account and invest the money in a variety of mutual funds. This type of HSA can supplement your overall retirement savings while protecting you with the health insurance coverage you need.

6. Buy U.S. Series I Savings Bonds

This is an often-overlooked but great way to earn a return indexed to inflation. Earnings are not taxed by your state or local government, and federal taxes are deferred while you hold the savings bond. Series I Savings Bonds can be used for higher education tax free (although 529 plans usually offer superior returns). The maximum amount you can buy is $10,000 per Social Security number, and you can choose to use up to $5,000 (per Social Security number) of any IRS refunds owed to buy more. You can consider them part of your retirement savings, but you don’t need to hold them in an IRA or 401(k) to defer taxes on your interest earnings.

When deciding whether to invest in Series I bonds, compare today’s rates with other investment opportunities. The U.S. Treasury publishes updated rates on the Treasury Direct website. At a minimum, the rate will keep up with inflation (CPI).

7. Municipal Bonds and Master Limited Partnerships (MLPs)

For investors in the highest tax brackets, these can be attractive tax-advantaged investments. Interest from tax-exempt municipal bonds is exempt from federal tax and sometimes from state tax (depending upon where you live and which bonds you buy). They offer lower interest rates than most taxable bonds, but you keep most or all of the interest you earn. Some are very high quality, with virtually no risk the issuer will default, but some are risky.

There are over a million muni bonds out there, so you’ll need a broker to help you find the kind that’s right for you. You can either keep them until they mature or sell them before then. Or you may prefer to buy a muni bond mutual fund or ETF to diversify. If you live in a state with a high personal income tax, such as New York or California, you can find funds that hold only bonds issued in your state, so the interest is all tax free for you.

Master limited partnerships (MLPs) are a way to get some cash flow while deferring most of the return for many years. A disadvantage of MLPs is they are quite complex to deal with when filing your taxes and usually require help from professional tax preparer or CPA.

Summary

Being tax-aware with your saving and investing can make a big difference in how much of your hard-earned income (including investment income) you keep versus the amount you have to pay in taxes. As long as it’s legal, we’re all in favor of keeping your tax payments to a minimum. Oh, you can put your hand down now.