Today’s Personal Investment Tip is about the relationship between tax advantaged accounts, such as IRA’s and retirement accounts, and the outcome or investment objective you have for each investment. By tax advantaged account, am referring to an account that is either tax free, or, more commonly, tax deferred, meaning you’ll pay taxes on the account’s investment returns, you just don’t have to pay until later. You probably already know the importance of wealth compounding tax free since it grows significantly more than wealth that is taxed; the difference is enormous. It is so huge, that it greatly affects when you reach your financial goals.
There are tax reducing strategies that can be put in place, such as real estate investing and small business ownership, but just placing your investments in the right type of account from a tax standpoint is simpler than most other alternatives for lowering your taxes. Something so simple with such a significant outcome deserves your attention to make sure it is done right. This is accomplished by having an awareness of how the objective of an investment, such as income or capital appreciation, relates to whether the account that holds that investment is taxable or tax deferred. In other words, if you have a bond fund in a non-taxable account, then you won’t be paying tax annually on the income you receive from the bond fund.
In general, most investment income is taxed at your highest tax rate; On the other hand, capital appreciation usually (but not always) occurs over a time period of more than one year, thereby allowing gains to be taxed at a lower rate. Remember from last week’s post, a gain is not realized, or taxed, until the investment is sold.
Tax efficiency is one of the things that financial planners and some financial advisors work on with their clients. If you are not working with a financial professional, look at your investments to ensure you have each one placed tax efficiently. If you do work with a financial advisor, make sure this is being addressed with each of your investments. A financial woman makes certain her portfolio is compounding as advantageously as possible.