A Guide to Tax-Efficient Investing

Potentially maximize returns and reduce tax liability with tax-efficient options.

March 4, 2016


When you invest, you can potentially maximize your returns by focusing on tax-efficient investments. Wise investors aim to take advantage of as many potential tax benefits as possible with their investments in order to reduce their future tax bills. How might you achieve your investment goals and reduce your tax liabilities? Consider any of the following tax-efficient investments for your portfolio.

Tax-Deferred and Tax-Free Investments

Annuities, traditional individual retirement accounts (IRAs) and company-sponsored retirement savings accounts, such as thrift savings plans (TSPs), 401(k) plans and 403(b) plans, are considered tax-deferred accounts. Depending on the type of account, contributions to these plans may or may not be tax-deductible, but your earnings will grow tax-deferred until withdrawal, when you may be in a lower tax bracket.

Tax-free investment options include Roth IRAs and Roth 401(k) plans. While contributions to these plans are not tax-deductible, your earnings will grow tax-deferred and can be withdrawn tax-free if certain requirements are met. (Generally, the funds must be held for at least five years, and you must be at least 59½ when you begin taking distributions.*)

If possible, consider investing the maximum amount into all tax-advantaged account options available to you. By reducing your annual tax liability, you increase your potential to save more for retirement.

529 Plans

529 plans are educational savings accounts that are operated by states and educational institutions and designed to help families save for qualified K-12 and college expenses. While contributions to a 529 plan are not federally tax-deductible, investments grow tax-deferred, and withdrawals are free of federal taxes when used to pay for the beneficiary's qualified educational costs. Additionally, many states also offer tax breaks to 529 investors, such as an up-front deduction on contributions or income exemption on withdrawals.

Unlike many other types of tax-advantaged investments, there are generally no age restrictions or income limitations on 529 investing, and the lifetime amount you can contribute to a 529 plan is substantial: more than $300,000 in many state plans. You can set the plan beneficiary to be anyone: child, grandchild, friend or even yourself! The primary requirement is that the invested funds must be ultimately used to pay for education from a qualified primary, secondary or post-secondary educational institution.

Municipal Bonds

Municipal bonds, issued by state and local governments to raise money for a variety of needs, are known as tax-free dynamos due to their built-in tax advantages. The interest income you receive from municipal bonds and municipal bond funds is free of federal income tax. In addition, in most states, interest earned on bonds issued by state and local government entities within the state is also exempt from state and local taxes.

How much of a tax-saving benefit might a municipal bond provide? To find out, compare the return of a tax-free municipal bond with a taxable bond. In the hypothetical example below, even though the taxable bond has a higher rate of return than the tax-exempt bond, your after-tax yield is lower. The inherent tax advantage of a municipal bond becomes even greater when its rate of return is even closer to a taxable bond’s return.

Comparison of Tax-Exempt and Taxable Bonds

Asset Type 5.0% Tax-Exempt Bond 7.0% Taxable Bond
Cash investment $10,000 $10,000
Annual interest $500 $700
33% Federal income tax $0 $231
Net return $500 $500 $469
After-tax effective investment yield 5.0% 4.7%

Check With Navy Federal

Considering the number of investment options available, you’ll want to pick the one(s) most appropriate for your age, investment goals and timeline. Talk to a Navy Federal Financial Advisor for personalized investment and retirement information.

*Consult with your tax advisor for details.

This article is intended to provide general information and shouldn't be considered legal, tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how certain laws apply to your situation and about your individual financial situation.