TAX FREE OR TAX DEFERRED? That Is the Question

By Robin S. Davis, CFP®

As we scramble to get those last minute tax forms, 1099’s, and K1’s in order, and race to the April 15^th finish line, we can reflect on those moments when qualified dividends, adjusted gross income, and tax credits were not a part of our everyday vocabulary.   Whether you sweated over doing your own tax return, or happily handed your pile of documents over to a reputable tax preparer, you now either have a smile on your face due to the big refund you will receive sometime in the future, or you are devastated as you shakily write out a check to cover the “amount you owe”.  The latter will disappear from your checking account quicker than a rabbit running from a fox as the refund will make its way to your mailbox on snail time.

There are many ways you may be able to lessen the tax bite you experience each year by educating yourself about smart tax-saving strategies available to you. Two of these strategies involve investments that generate either tax-free (also known as tax-exempt) income, or tax-deferred (also known as tax-sheltered) income. 

Tax-free income is derived from municipal bonds (muni’s) sold by state and local governments. This income is generally exempt from Federal tax and may also be exempt from state and local taxes if you are a resident of the locality where the bonds are issued. You can buy muni’s as individual bonds, or as a money market or mutual fund, which consist of many bonds. To determine if tax-free investing should be a consideration, you must first compare the tax-free yield to yields of corporate bonds or other taxable investments. For example, an investor in a 35% tax bracket with a 5% tax-free yield would be equivalent to a taxable yield of 7.69%.  You may be better off paying taxes on an investment earning more than 7.69%, as, after taxes, you still get to keep the lions share. 

Another way to grow your money on a tax-free basis is to contribute to a Roth Individual Retirement Account (IRA) if you are eligible. As long as you follow the strict IRS rules governing Roth IRA’s, you can use this strategy to eliminate federal, state and local taxes on future withdrawals, which also applies to your beneficiaries if they inherit this type of investment account. In 2008, the maximum contribution to a Roth IRA is $5,000 if you are under age 50, and $6,000 if you are over age 50. 

If you would like to delay paying taxes on your earnings to the tax year of your choice, you may want to entertain the strategy of investing in tax-deferred annuities. There are two types of annuities: fixed annuities and variable annuities. Fixed annuities are similar to CD’s in that they generally pay a fixed rate of return for a specified period of time. The difference is that CD income is usually taxable in the year received while annuity earnings are taxable when withdrawn. Variable annuities consist of separate accounts that are similar to mutual funds which will fluctuate with changing market conditions. Variable annuity earnings are also taxed when withdrawn. The benefit of tax-deferred growth is the fact that you can choose to pay taxes on withdrawals in a year when your tax bracket may be lower, or when you need to use the money as opposed to having to pay taxes as it is earned.

Other tax-deferred investments would include traditional IRA’s and 401k’s, as well as many other employer sponsored retirement plans. You must follow all IRS rules and contribution limits, which will vary on each plan in order to qualify for the tax-deferred status. 

There is still time to utilize some of these options to lower your tax bill for the year 2008. This information is by no means a direct recommendation, but a suggestion to bring up the topic with your financial professional to determine if these ideas, or the many other tax-advantaged investments available to the public, are right for your specific situation. 

Tax-free and tax-deferred investments have specific advantages, but also carry certain risks, which may not guarantee the return of your principal. As some of these investments may be subject to capital gains taxes, or the alternative minimum tax (AMT), I recommend consulting with your tax advisor before investing. 

We all must pay taxes in order to live in a civilized society. However, no one wants to pay $1 more than they have to. Keep in mind that by working with a competent, ethical team of advisors, you may be able to keep more of what you make.