Which Investment Types Are the Most Tax-Efficient?

Daniel Penzing
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Invest Through a Roth IRA

Contribute to an Employer-sponsored 401(k)/403(b) Plan

Contribute to an Employer-sponsored 401(k)/403(b) Plan. 401(k) and 403(b) plans are the most tax-advantaged retirement saver accounts available. You should contribute the maximum amount that your employer will match.

These contributions are fully “tax free” if you are young, and assuming your tax rate stays the same in retirement, you will also receive a huge tax savings as a result of the deferral.

Even if your tax rate is likely to decline in retirement, you still are in a more favorable tax environment now whereas in retirement you could face an unfavorable one.

Contribute to a Traditional IRA

If you are going to invest in a retirement account, then a Traditional IRA is the best type of account for you. A Traditional IRA is a tax-deferred account in which your contributions are tax-deductible and your earnings on the investment grow tax-free until you start to withdraw in retirement.

A Traditional IRA normally has lower contribution limits than a Roth IRA, although there is an exception for those that are self-employed. Also, you cannot contribute to a Roth IRA if either your modified adjusted gross income or your taxable compensation is above a certain level.

Overall, this is one of the best types of investment for most investors and most situations.

Save for College With 529 Plans

What are the tax benefits of 529 plans?

Pay Medical Expenses With a Health Savings Account

(HSA)

When you buy health insurance, you need to pay certain medical bills with pay check withholdings or out of pocket. If you do that with an HSA, then you can deduct that money from your taxable income.

Buy U.S. Series I Savings Bonds

United States Savings Bonds are U.S. Treasury bonds purchased for a specific amount of money and held for a minimum of five years. Several types of U.S. Savings Bonds are offered because each one serves a specific purpose in the U.S. National debt. You can purchase Series EE or Series I savings bonds.

EE Bonds Series EE U.S. Savings Bonds earn a fixed rate of interest throughout its term. The Series EE Bonds is issued in paper form or electronic form with a My EE Bonds account. The investments’ value will be credited electronically to your account every month. It will be directly deposited into your account and can be used as a checking or savings account.

Unlike other types of bonds, EE Bonds are indivisible. If you hold an EE Bond and pass away, the amount is paid to your beneficiary. There are two types of Series EE U.S. Savings Bonds:

Series EE Savings Bonds

Series EE Savings Bonds are issued at their face value. They are purchased at a discount. The Series EE Bond will pay interest for 30 years. If you hold the bond for 5 years, you will receive 5% annual interest. If you hold it for 10 years, you will get back the full market value of the bond plus interest, and the bond will be worth 100% of its original purchasing price. Issued in paper form.

Municipal Bonds and Master Limited Partnerships (MLPs)

Municipal Bonds:

  • are safe and offer fixed tax withholding every year
  • are issue by state or local governments
  • are exempt from federal income tax – this safety offers tax-deferred positive growth, meaning your investment compounds without being taxed until you sell your holdings
  • are exempt from state income tax in most states
  • are exempt from all qualified taxes – if you hold the investment in a tax-advantaged account, such as a 401(k)

MLPs:

  • are partnerships that are set up to own oil pipelines and gas pipelines
  • own more than 70,000 miles of oil and natural-gas pipeline
  • are beneficial for investors because they typically have a high yield and low risk – the risk is comparable to that of high-dividend stocks with low to medium volatility
  • are typically more volatile than many other types of investments – the price of an MLP can rise and fall dramatically depending on the price of oil and the condition of natural gas markets
  • are subject to the MLP income tax rules – the pass-through income generated by the MLPs is considered part of the investor’s ordinary tax income, and must be reported each year
  • are beneficial for investors due to the investor incentive program – MLPs typically have a high yield and are less volatile, but also offer tax incentive programs that greatly reduce the tax burden on investors

Summary

There is a lot of confusing information about the tax-efficiency of different investments.

You can make a case for some investments being more tax-efficient or being less tax-efficient than other investments in certain circumstances, so it’s not as simple as drawing a line and assigning an ‘x’ for each investment type.

But, broadly speaking, there are some things you can say about the tax-efficiency of certain investments.