A saying among investment old-timers is, "It's not what you make; it's what you keep." One of the primary factors that affects how much of the return on your investments you get to keep is the amount of taxes you have to pay. The Internal Revenue Service recognizes three tax structures for investments: taxable, non-taxable and tax-deferred. Which type of investment structure is best for you depends on your current and projected future financial situation.
The IRS considers all income that is not specifically exempted from taxation to be taxable income in the year it is received. You can receive taxable investment income in a variety of ways, including capital gains, interest, dividends, rents and royalties. While long-term capital gains, which are gains on the sale of an asset you have held for more than one year, are typically taxed at the more advantageous long-term capital gains rate, most other investment income is treated as ordinary income and is taxed at your current tax rate.
Some types of investments and investment accounts qualify for tax-deferral, which means you pay taxes on the investments when you liquidate, or sell, the investments. Certain equity investments, such as stocks, can be considered a tax-deferred investment. Although you will have to pay current taxes on any dividends you receive, you won't pay taxes on any growth in the market price of the stock until you sell it. Some types of accounts, such as a traditional individual retirement account, allow all investments inside the account to grow tax-deferred. You won't pay any income taxes on these funds until you withdraw them. U.S. savings bonds allow you to choose whether you want to pay taxes on the interest each year or to defer taxes until the bonds mature.
Certain types of investment income are exempt from federal income taxes. The interest paid on most municipal bonds is free from federal income tax and might also be free from state income taxes for bondholders who reside in the state of issue. The investment earnings in a Roth IRA grow tax-deferred as long as they remain in the Roth account, and once you reach age 59 1/2 you can withdraw those earning tax-free, provided you've had a Roth IRA account for at least five years.
Tax-deferred investments have the advantage of growing more quickly than investments that are subject to current taxation. For example, a taxable investment of $4,000 per year for 15 years that grew by 8 percent annually would result in a final balance of $108,276 for an investor in a 25 percent tax bracket. The same investment in a tax-deferred account would result in a final balance of $129,986, according to the Horizon Bank website. You should consider your current tax bracket as well as the tax bracket you expect to be in when the tax deferral ceases. If you expect to be in a significantly higher tax bracket later, you might be better off paying current taxes now to avoid the higher taxes then.
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.