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The first step to choosing tax-advantaged investment vehicles
is understanding the terminology. Here are some explanations.
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Pretax. Refers to amounts that can actually be deducted
from your income before it is taxed. This is where building
wealth really starts, and we'll cover the many types of these
accounts later. The most common example is a company
401(k) plan. Here's how it works: If you contribute 10% of
a $60,000 salary to a 401(k), you're putting the full $6,000
toward your retirement. Without a 401(k), this amount would
be taxed, leaving you with only $4,200 left to invest.
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Amount to be invested:
($60,000 salary x 10%) by employee |
| Taxes paid at 30% before investing |
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| Net invested by employee |
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Tax-deductible. Refers to a reduction in your current-year
taxable income. In some cases, you can reduce your taxable
income by contributing to a Traditional IRA. For example,
let's say that Mark makes a $1,000 tax-deductible contribution
to an IRA; he can lower his taxable income by $1,000. In a
25% tax bracket, that puts $250 more in his pocket.
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Tax-deferred. Refers to income and earnings that are not
taxed until a later date. For example, if you have a Traditional
IRA, the earnings are not taxed until the funds are withdrawn.
In the meantime, your money can grow and your earnings can
compound over time. The chart to the right shows the power
of tax-deferred investing.
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Tax-free. Refers to investments that provide income free
from federal and/or state taxes. For example, if you have
earnings from a municipal bond fund, a Roth IRA, or a 529 plan,
it is free from federal taxes under most circumstances. That can
make a substantial difference, especially if you're in a higher
tax bracket.
The next step is to understand
your investment options.
With careful planning, you can easily select investments
that will have less impact on your tax bill, resulting in a
higher after-tax return potential. Again, knowing what you're investing for, how long you need to
invest, what your risk tolerance is, and your current income tax bracket, are key to deciding which tax-advantaged investments are best for you.
Whether you're planning for retirement, putting money
away for college costs, or seeking to maximize investment
income, we'll discuss a variety of tax-advantaged
investment options. Consider
their role in your portfolio.
 Next: Planning for Retirement
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