Can you ever escape taxes?
As Benjamin Franklin put it, “nothing can be said to be certain, except death and taxes.” But was he correct? Certainly, no one has managed to escape death forever (not yet, anyway!). But can you really never escape taxes either? Let’s look at taxable and non-taxable accounts, and see if Ben was on the money (pun intended).
Taxes are an important consideration when investing, and they apply to both your accounts and individual investments. Managing your taxes properly, and taking advantage of tax deductibility and deferral, can help you achieve your financial goals more quickly.
Double taxation is bad for your bottom line
Accounts subject to tax (i.e., taxable accounts) generally include all non-retirement accounts, such as brokerage accounts. Not only is the money you invest already taxed (e.g., you pay taxes on your income before you even get it in your hot little hands), but your realized investment gains, dividends, and interest income are usually subject to taxes as well!
Saving for retirement can help you avoid taxes
Non-taxable accounts include 401(k) plans and IRAs. Different rules apply to different accounts, so it’s important to consult an expert to find out how the rules apply to your specific situation. For instance, 401(k) plans and traditional IRAs are tax-deferred because you can invest with pre-tax dollars, or deduct the amount you invest in them each year from your income taxes, respectively. However, your investment gains will be taxed when you withdraw from the accounts.
In terms of individual investments, your investment gains on most stocks, bonds, and other assets in these non-taxable accounts are still taxable. The exceptions are non-taxable investments such as municipal bonds. Munis, as they’re often known, can be used in investment accounts to help provide income and minimize taxes from interest income, but usually come at the expense of lower expected returns. The interest from these investments are usually tax-free at the federal level and potentially the state and local level too, depending on the bond and the investor. Proceeds from the sale of these investments would still be subject to tax.
Help maximize your tax benefits with tax-deferred retirement accounts
To gain the greatest tax benefits, it may be beneficial for investors to contribute the maximum amounts to their tax-deferred retirement accounts and minimize taxable events in their other accounts. One important note is to avoid investing in non-taxable investments in tax-deferred accounts, because you’ll lose the benefit of tax deductibility.
So, perhaps Mr. Ben Franklin was onto something. While you can’t escape taxes entirely, you can take steps to maximize your gains by minimizing your tax deductions strategically.