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Investing | Making the Most of Favors
Believe it or not, sometimes you get a break on your taxes.
Investing for retirement is different from any other type of investment for one big reason. There’s a great tax deferral incentive built in. Tax-deferred investments allow you to postpone the taxes on earnings, and in some cases on the amount you’re investing as well. Deferral not only delays the tax bite, but gives your money’s growth a boost because compounding has a bigger base on which to work its magic and, in the best of circumstances, a long time frame.
Choosing InvestmentsAre the investments you choose for a tax-deferred plan different from investments you’d pick for your other accounts? The answer is yes and no. All long-term investment portfolios need to grow. That means focusing on equities, specifically stocks and mutual funds and variable annuities that invest in stocks. You need diversification in your tax-deferred plans as well. Since equity markets go through cycles, when some types of stocks turn in stronger performances in one phase and other stocks shine in another, being diversified helps even out the ups and downs. The eventual tax you’ll pay on your tax-deferred earnings—at the same rate you pay on other income, rather than at the lower capital gains rate—may influence the types of equities you stress, though. Some experts suggest choosing those that pay little current income but promise strong growth in taxable accounts, while buying those that produce income as well as growth in your tax-deferred plans. You might also consider high-yield bond funds, which can produce a lot of income. But it’s smart to avoid municipal bonds in a tax-deferred plan since the interest they pay is tax-exempt in a taxable portfolio but becomes taxable when you own the bonds in a tax-deferred plan. You would generally be better off investing in a taxable bond in the first place since taxable bonds provide higher yields than comparable municipal bonds. Moving Things Around
Another advantage of tax-deferred plans is that you can transfer assets among the investment accounts without paying tax on any gain in value. That’s not the case with taxable investments. For example, if you own shares in a mutual fund that has increased in value and you liquidate, or sell off your shares in the fund, you’ll owe capital gains tax on your profit. But if you have shares in an equity investment portfolio in a variable annuity, you can move your investment out of that portfolio and into another one offered through the annuity without paying any tax on an increase in value until it's withdrawn. You can do the same thing with investments in IRAs, 401(k)s, SEPs, and other tax-deferred plans.
Rolling Them OverYou can move your tax-deferred investment plans from one trustee or provider to another and preserve their tax-deferred status. The process is called a rollover or transfer in some instances and a non-taxable exchange in others, depending on the plans in question. For example, if you leave an employer where you had a 401(k) plan, you can roll over your investment into a 401(k) at your new employer or into an IRA, continuing to defer your tax burden until you start to make withdrawals. Similarly, you might want to invest your IRA in a variable annuity to take advantage of being able to arrange to have regular income distributed over your lifetime. If you want to exchange a variable or fixed annuity contract provided by one issuer for a contract offered by another, you can do that too. The transaction, known as a 1035 exchange, is named for the section of the Internal Revenue Code that makes it non-taxable. Tax-Exempt Investing
If tax-deferred is good, tax-exempt can be better. Certain retirement vehicles allow you to grow your money and never pay any tax on the earnings. The classic tax-exempt investments are municipal bonds issued by state and local governments. The interest is exempt from federal tax and exempt from state and local tax if you live within the locality where they are issued. For example, a resident of Virginia pays no state tax on a bond issued there, though would owe state tax on a bond issued in Tennessee. In 1997, Congress created a new tax-exempt IRA, called a Roth IRA for Senator William Roth (R-DE), who pushed for its passage. With the Roth IRA, investors contribute after-tax dollars to the account. As long as the Roth IRA remains open for five years and you’re older than age 59 1/2 when you withdraw, the earnings are tax-free. There are some limits with Roth IRAs. Your contribution is capped at the limit that applies for that year, though you can roll over your existing IRAs into a Roth. There are also income limits, so that you can’t contribute to a Roth if you have an adjusted gross income of more than $110,000 if you’re single or a combined income of more than $160,000 if you’re married.
When you do start to make withdrawals from your retirement accounts, you’ll owe tax on the earnings as you withdraw them. If contributions were also tax-deferred, as they would be in a qualified plan, you’ll owe tax on the total amount you withdraw. In some cases, all of your earnings are paid before you begin to get your principal back. But with a non-qualified annuity, you can choose an income plan that returns some of your premium with each withdrawal, reducing the tax you owe.
