Before you invest money in anything, regardless of how safe or risky the product might be, it's a good idea to take a look at your overall financial plan. Things to consider include whether your current financial situation justifies the investment, and whether the investment is a good match for your financial goals. You should also ponder any tax liability that will be triggered when you decide to take money out of the investment.
Saving vs. Investing
Saving typically involves setting aside a portion of your money in a safe, secure, readily accessible place. This can range from putting some money in your cookie jar, to opening a passbook savings account with your local bank. Investing usually involves a greater degree of risk, as well as a greater opportunity for gain. While you typically deposit money into savings, you usually buy an investment product. Withdrawing money from your savings account does not create a taxable event. You must usually sell all or a portion of your investment if you wish to take money out, and that almost always triggers a taxable event.
The Internal Revenue Service considers just about everything you own, including your investments, to be capital assets. If you sell an investment for a profit, you have a taxable capital gain. If you sell at a loss, you can use that capital loss to offset some of your capital gains and reduce the amount of capital gains taxes that you are liable for. It is also possible to sell the asset for the same amount as your basis, in which case you would have neither a gain or loss. Capital gains are taxed as either short-term or long-term gains. If you have to take money out of an investment before you've owned it for more than one year, your gain or loss will be short term and any profit will be taxed at your ordinary income tax rate. If you hold the investment for more than a year, your gain or loss is long term and any profit is taxed at the more advantageous long-term capital gains rate.
Investments held in your traditional individual retirement account have the advantage of growing tax-deferred, but you will incur a tax-liability when taking money out of your IRA. You can only withdraw cash from your IRA, so your plan trustee will have to liquidate enough investments in the account to satisfy the amount of your withdrawal. Selling the investments in your IRA does not create a taxable event, but taking money out of the account does. The Internal Revenue Service treats all withdrawals from a traditional IRA as ordinary income, and early withdrawals are subject to an additional 10 percent tax penalty.
Investments held in your Roth IRA are also allowed to grow tax-deferred. You can use the money in your Roth IRA to buy and sell a wide variety of investment products without generating either a capital gain or loss. Since you have already paid income taxes on the money you contribute to a Roth IRA, you can withdraw all of the money you contributed to the account at any time without creating a taxable event. You must have a Roth IRA for at least five years and be 59 1/2 years old before the earnings become qualified for tax-free withdrawal. If you take earnings out before they are qualified, the IRS will tax them as ordinary income and hit you with an additional 10 percent tax penalty.
If you are in a high tax bracket, you might consider investing in municipal bonds to obtain a steady stream of tax-free interest. You can usually sell your municipal bonds in the secondary market if you need to take money out of your investments. The market price of tax-free bonds tends to rise or fall in the opposite direction of prevailing interest rates, so you might sell your bonds at a profit or a loss. While the interest on municipal bonds is usually free from federal income taxes, any capital gain you earn from the sale of the bond if fully taxable at the federal, state and local level.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.