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Tax Benefits of Certain Investments*

You can invest your money in tax-exempt and tax-deferred investments that will help you accumulate wealth quickly.

Tax-Deferred Investments

Investing in a tax-deferred retirement plan is an effective way for you to save money. It's actually a double savings because you're not only saving for retirement; you're also saving money on taxes. With a tax deferral, you pay the tax later. In the case of a tax-deferred retirement plan, you don't pay taxes on the money until you withdraw it at your retirement. The taxes are typically lower than when you're working because you're usually in a lower tax bracket after retirement. In most situations, the government allows you to reduce your taxable income by the amount of your contribution to a tax-deferred retirement plan. In effect, you're investing the money that would have gone to the government.

401(k) Plan

The most common tax-deferred investment is an employer-sponsored 401(k) retirement plan. With this type of account:

  • Contributions are deducted from your pay pre-tax, before federal income tax.

  • Many employers match some or all of your contribution, which increases the amount in your retirement fund.

  • You can typically borrow against the balance of your account without paying an early withdrawal penalty.

Besides the traditional 401(k), there are the following:

  • Safe Harbor 401(k) – The Safe Harbor 401(k) plan exempts companies from tax rules that limit the amount of deferred salary contributions to the plan, as long as the employer makes a certain minimum percentage contribution to each participating employee's retirement account.

  • SIMPLE 401(k) – The Savings Incentive Match Plan for Employees (SIMPLE) 401(k) is a plan similar to the Safe Harbor 401(k) for businesses having 100 or fewer employees.

  • Roth 401(k) – The Roth 401(k) plan differs from a traditional 401(k) in that contributions are taxed at the beginning rather than at the end (when you close your retirement account and take the money). This is especially beneficial if your retirement account is held for many years.

Check with your Human Resources/Benefits Department for more information on these options. Search the U.S. Internal Revenue Service (IRS) website for more information about 401(k) plans. Also see the Federal Citizen Information Center article Life Advice About 401(k) Plans.

IRA

Whether or not your employer offers a 401(k), you might want to invest in a traditional Individual Retirement Account (IRA). Features of this type of account include:

  • You must be younger than age 70½ and have earned an income to open this account.

  • You can contribute up to a maximum of $4,000 per year ($5,000 per year if you have reached age 50). If you and your spouse file a joint tax return, you can each contribute to separate IRAs with a total contribution limit of $8,000 to $10,000. (In 2008 the contribution limit rises to $5,000 per year / $6,000 over age 50. After that, IRA contribution limits will be adjusted for inflation each year).

  • You may be able to deduct the amount of your contributions from your federal income tax, if your annual income falls beneath a certain amount.

  • Early withdrawal prior to age 59½ results in a 10% penalty. (A tax loophole, known as the 72(t) exception, allows untaxed early withdrawals if they are taken as a series of equal payments over several years. See the IRS article Retirement Plans FAQs regarding Revenue Ruling 2002-62).

  • Withdrawals can be penalty free in certain cases, including paying for higher education, a first-time home, or some medical expenses. For a detailed explanation of the exceptions, see the American Institute of Certified Public Accountants (AICPA) article Withdraw Without Penalty.

  • Short-term loan withdrawals are free of penalties as long as the money is returned to the IRA account within 60 days (once per year only).

As part of the Pension Protection Act of 2006, military reserve personnel who were called to six months of active duty between September 11, 2001 and December 31, 2007, are entitled to take a penalty-free withdrawal from their IRA or 401(k) plans. If they redeposit the withdrawal within two years after the end of active duty, the funds will not be subject to federal income tax. See the Special Summary of the Pension Protection Act of 2006 for more changes affecting retirement plans.

See the Internal Revenue Service (IRS) Publication 590: Individual Retirement Arrangements for more information about traditional IRAs and Roth IRAs.

Roth IRA

The Roth IRA was created by the 1997 Taxpayer Relief Act to help low- to middle-income people save for retirement. The Roth IRAs are different from traditional IRAs as follows:

  • Your adjusted gross income must be less than $110,000 if you file a single tax return, or less than $160,000 if you are a married couple filing a joint tax return.

  • Contributions to Roth IRAs are not tax deductible.

  • You can contribute to a Roth IRA after age 70½.

  • Withdrawals after age 59½ are tax-free and penalty-free as long as 5 years have passed since the first contribution.

  • Annual contributions (but not the earnings on those contributions) can be withdrawn without tax or penalty at any time.

  • Withdrawals before age 59½ that are not the exceptions described in the IRA section above are subject to penalties (10% and income tax) only on the earned interest, not the original contribution, of a Roth IRA.

Keogh or Qualified Plan

A Keogh is a tax-deferred retirement plan for small businesses. Keogh plans offer either profit-sharing or money purchase benefits to the participants. The contribution limits on Keogh plans are the lesser of 100% of your income or $45,000 per year (as of 2007). If you are the business owner, you must also contribute for your eligible employees. Search the IRS website for more information about Keogh plans, and read IRS Publication 560.

Other Plans

Other tax-deferred retirement plans include:

  • SEP-IRA – Simplified Employee Pension plan. Small business owners can contribute to their employees' IRAs without going through the complex setup of other retirement plans. Contributions to an SEP-IRA have a maximum limit of $45,000 per year (increasing for cost of living adjustments after 2007) or 25% of the employee's annual salary, whichever is less.

  • SIMPLE-IRA – Savings Incentive Match Plan for Employees. A SIMPLE-IRA is similar to an SEP-IRA, except that the employer's maximum matching dollar-for-dollar contribution can be as little as 3% of the employee's annual salary. The employee can contribute up to $10,500 ($13,000 if age 50 or older) of annual salary to a SIMPLE-IRA.

See Chapter 2 and Chapter 3 of IRS Publication 560 for more information about SEP- and SIMPLE-IRAs.

Tax-Exempt Investments

There are investment options where you can earn interest tax-free. In other words, the interest income, or the earnings on your investment, is exempt from some form of income tax.

Coverdell Education Savings Account (formerly Education IRA)

Investing in a Coverdell Educations Savings Account (ESA) for your child's college (or primary or secondary school) education gives your child the benefit of tax-free withdrawals, as long as the educational expenses for the year equal or exceed the amount of the withdrawal. Any person, including the child beneficiary, can contribute to a Coverdell ESA. The beneficiary must be younger than age 18.

In order to make the maximum contribution of $2,000 per year, the modified adjusted gross income of the contributers to a Coverdell account must be less than $95,000 for those filing single returns or $190,000 for joint returns. Single filers with incomes from $95,000 to $110,000 (joint return income $190,000 to $220,000) can make contributions that are a fraction of the $2,000 limit, as specified in chapter 7 of IRS Publication 970: Tax Benefits for Education.

See the IRS article Coverdell Education Savings Accounts for more information.

Municipal Bonds

State or local governments issue municipal bonds for the purpose of earning money to repay debt. The interest earned is exempt from federal income tax, and may also be exempt from state income tax if the bond is issued in your state of residence, or if there is a reciprocal agreement between your state and the state where the bond is issued. Because municipal bonds usually offer a lower rate of interest than other taxable investments, they may not be a worthwhile investment for you. See the Investopedia article Weighing the Tax Benefits of Municipal Securities for more information.

Series EE U.S. Savings Bonds

While the interest earned on savings bonds is subject to federal income tax, it is exempt from state and local income tax. See the U.S. Treasury Department Bureau of Public Debt booklet The Savings Bonds Owner's Manual for more information.

The Bottom Line

Both tax-deferred and tax-exempt investments are good options to consider. With the tax-deferred investment options listed above, you'll not only save money for retirement, you'll also save money on your taxes. The tax-exempt investment options allow you to maximize your investment income by eliminating the tax penalty. The IRS has several helpful publications about retirement plans and savings investments. Visit www.irs.gov and search the website for more information.

Take control of your finances with our debt help tools. Use our calculators and budget planner to help you manage your money.

*This is not intended to be, and is not tax advice. It is always wise to check with a tax professional if you have any questions before filing your taxes. 
 

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