The Simplest Ways To Make The Best Of Tax-Sheltered Investments

Tax laws encourage certain types of financial investments or taxpayer behaviors by giving them distinct tax advantages. As a result, numerous tax-sheltered investments exist. A tax shelter is any financial arrangement (investment) that decreases or eliminates taxes due. Tax laws allow certain income to be exempt from income taxes in the current year or permit an adjustment, reduction, deferral of income tax liability. When making investment decisions, investors should consider tax-sheltered financial investments.

Invest with Pre-Tax Income

A financial investment contribution with pre-tax income means that you do not have to pay taxes this year on the income. Essentially, investing with pre-tax income is an interest-free deferral of income taxes to another year. An example is to make pre-tax contributions to an employer-sponsored retirement plan.

Make Your Investments Grow Tax Sheltered

Investors do not pay the current-year tax liability when income, dividends, or capital gains are tax-sheltered; instead, the liability shifts to a later year. This benefit is substantial! Investments can compound quicker because the money that would have been taxed by the government every year can continue to accumulate in investments for years to come. Tax-free growth of such investments is called tax-sheltered compounding.

Examples of Tax-Sheltered Investments

(Note: numerous tax-sheltered financial investments exist, these are a few prominent ones.)

Roth IRA Accounts

Contributions (up to $6,000 annually) to a Roth IRA accumulate tax-free, and withdrawals are tax-free. There is no tax break on Roth IRA contributions, as funds are after-tax money. A Roth IRA is an excellent financial investment vehicle for people with a long-term investment horizon. Particularly for those who want to save more retirement money than is possible with a retirement plan funded by their employers.

Individual Retirement Accounts

The amount contributed (up to $6,000 annually) to a Traditional Individual Retirement Account (IRA) is considered an adjustment to income, which decreases your current-year income tax liability. Investments inside the IRA (such as stocks and index funds) accumulate tax-sheltered. Upon eventual withdrawal, which is likely to occur during retirement, income taxes are due.

Coverdell Education Saving Accounts

Individuals may contribute up to $2000 annually of after-tax money to a Coverdell Education Savings Account (known as an Education Savings Account) to pay future education expenses. Earnings accumulate tax-free, and withdrawals for qualified expenses are tax-free. Recipients may use the money to pay for public, private, or religious school expenses in college or graduate school. An Education Savings Account can pay for tuition, fees, room and board, tutoring, uniforms, computers, internet access and related technology, transportation, and extended daycare.

Qualified Tuition Programs

There are two types of Qualified Tuition Programs, known as 529 plans. Under the Prepaid Educational Service Plan, an individual purchases tuition credits today for use in the future (also known as a State-Sponsored Prepaid Tuition Plan). This program enables parents, relatives, and friends to purchase a child's future college education at today's prices. The Prepaid Educational Service Plan guarantees that prepayments will be utilized for future tuition at an approved higher education institution in a specific state. The funds may pay for tuition only, not room, board, or supplies.

The second Qualified Tuition Program is the College Savings Plan, established for a designated beneficiary. College Savings Plans are provided primarily by state governments and can differ from state to state. Withdrawals are tax-free if made for qualified education expenses such as tuition, room, and board. If one child does not go to college, the funds can transfer to another relative. One may contribute to both a Section 529 and a Coverdell Education Saving Account for the same beneficiary in the same year.

Government Savings Bonds

 Series EE and Series I Government Savings Bonds are promissory notes issued by the federal government. The income is exempt from state and local taxes. You may defer the income tax until final maturity or report the interest annually. You may exclude accumulated interest from income tax in the year that you redeem the bonds to fund eligible educational expenses.

Tax-Exempt Municipal Bonds

Tax-exempt municipal bonds (also called Munis) are long-term debts issued by local governments and their agencies to finance public improvement projects. Interest is free from federal and state taxes when individuals purchase a bond from their state of residence. Taxpayers in higher-income brackets (28 percent or more) frequently take advantage of these kinds of financial investments. Investors should select bonds which, after payment of income taxes, pay the best return.

Capital Gains on Housing

A hefty tax-sheltered is available to homeowners when they sell their homes. Those with appreciated principal residences can avoid capital gains tax up to $500,000 if married and filing jointly and up to $250,000 if single. The home must have been owned and used as the taxpayer's private residence for two out of the five years immediately before the date of the sale.

Question: Is my stimulus payment taxable?

According to the IRS, no. The payment is not income, and taxpayers will not owe taxes on it. The payment will not reduce a taxpayer's refund or increase the amount they owe when they file their 2020- or 2021-income tax return this year or next year. Stimulus payments will also not affect income to determine eligibility for federal government assistance or benefit programs.