Foundations of Investments: How Taxes Apply to Investments

Welcome back to my series of blogs on the foundations of investments. In our first blog, we talked about the importance of setting a timeline for the goals you need to save money for and which saving or investment plan is best for achieving those goals. What we didn’t talk about is how taxes affect those different types of saving and investing and this is often an area that confuses a lot of people. There’s a reason why it can be confusing! The different types of taxes and how they are applied can be overwhelming—but that’s what you have me (and your financial advisor) for. We can figure out all the details for you, but I still think it’s a very good idea for everyone to have a basic understanding of how different types of accounts or products are taxed.

Taxed Now

When you put your money into savings or money market accounts to achieve short-term financial goals, your money is taxed now. This is the most predictable and safe way of saving money, which is why I encourage those trying to reach one to three year goals to use this method instead of getting involved with stocks, bonds, or other more volatile methods. There are a variety of different taxes that apply to these funds, but we won’t get into specifics in this post. Just understanding that these are taxed now is a good start, especially if you’re a young adult who is just learning how to monitor and manage your money effectively.

Taxed Later

Once you have set some more long-term goals and have worked with your advisor to determine your risk tolerance, you can start looking into investing in things like 401(k)s if they are offered through your work, IRAs, and other products that are what we refer to as ‘tax-deferred’. This means that your money is put into these account before taxes are taken out, which makes them a pretty good deal if the money is coming out of your paycheck or you’re getting an employer match. However, what you need to realize is that all the growth on this money will be taxed and that you’ll be ‘paying the piper’ when you’re ready to withdraw it. These investments come with quite a few rules about when you can take money out. If you try to take it out too soon, you could face stiff penalties and if you don’t take it out soon enough, you can be forced to start taking withdrawals at a certain age. That’s not to say these aren’t good options for a lot of people—you simply have to understand how they work and play by the rules to get the most favorable returns.

Never Taxed

Of course, the best of both worlds are those investments that are never taxed and yes! There are some. Roth IRAs are probably the best known investments in this area. These are great vehicles for investing if you meet the income and age requirements, but you can only put a certain amount in per year. That means you can’t fund your whole retirement with a Roth IRA, but it can sure help! Another investment that is never taxed is a 529, which is commonly known as a college savings plan. When used for educational purposes, the funds put into a 529 account are never taxed, so they’re a perfect way to save for your kids or grandkids’ post-secondary educational costs.

When you choose a financial advisor who prioritizes you, you’ll have a professional on your side who can help you choose the most beneficial investments and savings for you based on your priorities, goals, and lifestyle. Understand basics like timelines and taxes will help you make good decisions together that will help you live a financially successful life. Next up: how to choose where to invest.

Have questions or comments on taxes? Please leave them below!