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Why Tax-Deferred and Tax-Free Are the Best Ways to Invest

An old bit of (good) advice is that the best way to save money is to not spend it. We usually take that to mean curbing shopping sprees, eating at home more often, and maybe using coupons. But a big part of hanging on to your hard-earned cash comes before it ever hits your bank account. Depending on your income, you spend 10% to 37% on taxes, which, for most of us, are automatically deducted from every paycheck.

So how do you spend less on Uncle Sam? Send what you can into a tax-advantaged account. It’s the secret of the very wealthy: Keep more of what’s yours so it can continue to grow. Building real wealth also takes time, which is why saving for retirement is an ideal long-term strategy. However soon or far off that seems, it’s always closer than we think.

Which type of account is best? It depends, but it never hurts to have one of each. Here’s how the different types of tax-advantaged accounts work.

Tax-deferred. In this type of account, like a 401(k), the money is taken out of your paycheck before the government gets its cut, reducing the amount of money the government can tax. You invest that money for years however you want, and then when you’re eligible and begin to make withdrawals, that’s when you pay taxes on it, at the going rate. The advantage here is twofold: 1) you have a larger chunk of money to invest because it hasn’t been taxed yet; and 2) you have less income that the government can tax today.

And, if you lower your taxable income enough, you could get yourself into a lower tax bracket and pay even less in taxes overall. For example, if you made $90,000, which in 2019 was taxed at 24%, and put $6,000 into a 401(k), reducing your gross income to $84,000, which was taxed at 22%, you’d pay 2% less — or $1,680 — to the federal government.

It may not sound like much compared to your yearly income, but if every year you put that $1,680 into an account that compounds annually at just 3%, it would grow to $84,005 in 30 years. And just think: Even if you decided to take a vacation with the $1,680 that you didn’t pay in taxes, you’d still have the $6,000 you did invest each year growing for you in an account somewhere.

Tax-exempt. These kinds of accounts provide excellent ways to save money, but they’re geared toward folks who can benefit from what they offer. For example, a Health Savings Account (HSA) uses pre-tax income (that you can deduct from your gross income, like with a 401(k), up to an annual limit) and can be withdrawn tax-free, but you have to have a high-deductible health plan to qualify for one, and the funds have to be used for qualified medical expenses to avoid penalties.

Education Savings Accounts (ESAs; also known as Education IRAs) are funded with post-tax dollars (read: no deduction on your taxable income) that can be withdrawn tax-free, but only for qualified educational expenses.

But, if a high-deductible health plan or saving for your kid’s college is on your radar, these might be great ways to avoid the taxman.

Tax-free. Here, we’re basically talking about Roth accounts. Roth IRAs and Roth 401(k)s are actually considered tax-exempt, but because there aren’t any restrictions on what you can use the money for (like with HSAs and ESAs), I like to consider them simply tax-free. So yes, you do pay taxes on the principal up front; however, none of the interest and returns are taxed, ever.

That’s why Roths are perhaps my favorite type of account. Are your taxes really going to go down after you retire? Only if you’re going to reduce your current standard of living. If you plan on living in a similar location and maintaining the same lifestyle you have now, you’re likely going to need a similar income (or more, because costs are always rising), meaning you’ll be taxed at a similar rate. So if you pay the (same) taxes now, the growth can compound and you won’t have to worry about withdrawals pushing you into a higher bracket later.

No matter how you decide to build your wealth this year, the best way is to start now. With all of these tax-efficient accounts, your biggest advantage will always be the time your investments have to grow.•

These articles are not intended as investment or financial advice. Before making any investment decision, talk to your financial, tax, or legal advisers.

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