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How To Make Smart Tax-Advantaged Investment Decisions

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You can avoid costly mistakes if you understand the difference between tax-advantaged investments and tax-advantaged accounts.

What are tax-advantaged investments? Investments that people make specifically because of the tax advantages they provide are referred to as tax-advantaged investments. In fact, if not for the tax advantages, most people would not buy those particular investments. Tax-free bonds, fixed and variable annuities are examples.

Mutual funds offer tax benefits but they are not generally considered tax-advantaged because people don’t buy them specifically for the tax benefits. Real estate also has tax advantages but is also not generally included in this category. What’s important to keep in mind is that these investments have tax advantages regardless of what account you hold them in.

What are tax-advantaged accounts? Retirement accounts are tax-advantaged. Examples are IRA’s, 401(k)s, SEP IRA’s, ROTH IRAs etc. What’s critical to understand is that you can buy any investment you like within these accounts and the returns are tax-advantaged. The tax benefits don’t depend on the investments you make within these accounts.

Why are the differences important?

If you understand the difference, you’ll avoid costly mistakes. They are:

  1. Within a tax-advantaged account, all you care about is getting the highest return while taking the least risk. In effect, inside of a tax-advantaged account you have a level playing field. All the investments have the same tax benefits inside of these accounts. As a result, you’d almost never want to buy a tax-advantaged investment because they usually pay lower returns.
  2. Only buy tax-advantage investments in taxable accounts, you don’t gain any advantage if you buy them in an account where you aren’t taxed!

Let’s look at an example to clarify these rules.

Assume you are in the 30% tax bracket and you can earn 4% for 10 years on an annuity or a CD. You have $10,000 and you are trying to decide between the two choices.

Taxable Account Tax-Advantaged Account
A B
Annuity CD CD
Investment $10,000 $10,000 $10,000
Return 4% 4% 4%
Tax Rate 30% 30% 30%
Value in 10 years $14,802 $13,180 $14,802
Withdrawal Rate 4% 4% 4%
Net After-Tax Income $414 $369 $414

If you were making a 10 year investment in a taxable account (column A), the annuity looks better. It creates $414 in annual income while the CD only generates $369. This is because the CD in a taxable account is burdened with paying taxes each year while the annuity is not. As a result the annuity grows faster and as a result, generates more income.

In a tax-advantaged account (column B), the tax benefits of the annuity disappear. The CD is now on a level playing field when compared to the annuity. You’d buy the CD in this case because it has FDIC insurance while the annuity does not.

Why Advisers Sell Annuities

“My financial adviser is always trying to sell me an annuity (tax-advantaged investment) for my IRA (tax-advantaged account). Why?”

There are a few reasons; all of them bad.

Some annuity sales people say that you should invest in an annuity for your IRA because it has guarantees that the other investments don’t. What they often fail to mention is that the guarantee is only a death benefit so you have to die in order to get it. Not a good trade off.

Tax-advantaged investments, especially annuities, have lots of bells and whistles; very expensive bells and whistles and you pay for all of them. I’m not a fan of annuities – especially variable annuities.

Many people say you should not make an investment simply because of the tax advantages. This is good advice. Evaluate investments on
their own, without the tax benefits if you want to be a good investor. If you wouldn’t make the investment without the tax benefits, don’t make the investment at all. Tax laws change. As a result, what started out as a great investment could turn into a real dud. I rarely advise clients to make tax-advantaged investments.

Tax advantaged accounts are another story entirely. They can be great. In my experience, people often accumulate most of their wealth in tax-advantaged accounts – not tax-advantaged investments. This isn’t an accident. Within tax-advantaged accounts, most folks evaluate investments on their own merits so they invest smarter. It also doesn’t hurt that the tax penalty for invading these accounts acts as a barrier and keeps you from spending the money.

How would you compare tax-advantaged investments vs tax-advantaged accounts? Have you made any great tax-advantaged investments?

This is a guest post by Neal Frankle. Neal found himself in a financially fragile situation at the age of 17. Both his parents passed away while he was still in high school, leaving behind a small insurance settlement. Neal sought out a financial advisor to help him invest his nest egg so that it would help put him through college. Instead, the advisor charted a self-serving course and was on the verge of burning through the money when Neal realized what was happened and fired him just in time to avoid losing everything.

The experience had a deep impact on Neal and formed in him a lifelong desire to help people learn to make smart financial decisions. Today, with more than twenty-five years of experience in the financial services industry, Neal is an author and avid blogger. To learn more, visit www.wealthpilgrim.com.

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14 Responses to “How To Make Smart Tax-Advantaged Investment Decisions”

  1. My Journey says:

    ““My financial adviser is always trying to sell me an annuity (tax-advantaged investment) for my IRA (tax-advantaged account). Why?”

    There are a few reasons; all of them bad.”

    I completely agree that it shouldn’t be done for tax reasons, but what about other reasons.

    Assuming we are talking about fixed – could one reasonable reason be, to provide a steady stream of income from a company that is rated better than most Municipals?

    Even if we are talking about Variable – could a reasonable reason be, to take advantage of various riders that may “cost” a lot but provide a minimum benefit like a guaranteed income or withdrawal regardless of how the market does?

    I think these products have gotten a bad rap during up swings in the market like we had experienced, but they are Thriving in popularity right now accross the board cause you are letting an insurance company take the risk for you.

    Disclaimer: I do not own a qualified or non-qualified annuity.

  2. Well said Journey.

    I agree that under unique circumstances, a life annuity could work. If the investor is advanced in age and if interest rates are high enough, it could be a wise decision. As I’m sure you’ll agree, it depends on the clients’ circumstances.

    It’s just that in 25 years, I’ve only encountered one case when it made sense but I’ve met countless people who were sold this “solution” when it didn’t fit.

    On the variable side, I see your point and it’s well made but I have to respectfully take issue. The riders are available – at a cost. Usually, investors can get those same benefits with lower costs.

  3. My Journey says:

    Neal,

    I appreciate the professionalism of accepting an alternative view rather than dismissing it without giving it at least a review!

    Nice work.

  4. Dave says:

    I have a relative that purchased an annuity a few years ago who is close to retirement age and was interested in the steady income portion. She is not very good with money, and when I first heard that she had bought the annuity, I thought that she had been ripped off… as it turns out, if she had put the money into the market 2 years ago, a huge chunk of her nest egg would be gone, so from that perspective she got lucky. I could go on, but there’s a thread in the forums all about it… (Shameless plug for Jim’s forums, I know. :) )

  5. Dave – good point.

    My Journey….I was going to say the same thing about your comment. I really appreciate your articulation and calm tone. Great to be able to discuss…huh?

  6. Manshu says:

    That’s a good point. On the point of annuities though, even I’ve never come across anyone for who an annuity could be ideal.

    • Jim says:

      What about someone near retirement? Or someone looking to do a little estate planning? There are many situations where an annuity would be a good idea.

  7. Neal Frankle says:

    Jim,

    I appreciate your question. I can see how an annuity (under special circumstances) might help someone create retirement income – see my comments to My Journey please. But the annuity makes estate planning even more difficult.

    When a person dies, the annuity gains are taxed at ordinary income and the beneficiary has 5 years at most to withdraw the funds.

    Life insurance might be a better way to go for estate planning. Lots of tax benefits there.

  8. eric says:

    Informative thanks!

    For people who don’t qualify for tax advantaged accounts, say a non-working college student, is it advisable to go with tax advantaged investments in a taxable account?

    If anything, this makes me want to know more about the various tax advantaged accounts. Thanks Neal.

  9. newb says:

    What is never discussed is the safety of the insurance company behind the annuity…the insurance guys are as greedy and stupid as the bankers so who is to say the company behind the annuity will always be around to pay out…

    • My Journey says:

      Newb,

      That is just wrong. While AIG covers the news only 2 or 3 insurance companies went under last year vs tens of banks.

      But I think it is discussed, actually I said above about the Triple AAA rating?

  10. Eric,

    It would really depend on how long you want to invest for. You might want to invest for retirement and that might be ok but consider:
    a. after school, you will start working
    b. after school, you may want to buy a home or have other large expenses. You might need that money so you may want it liquid. Remember, if you buy an annuity, you really can’t touch the money until you reach 59 1/2.

    Hope that helps.

  11. eric says:

    Thanks for the reply!

    Actually I have a cousin who’s in this situation so that’s why I was curious. He wants to start investing for retirement (his other priorities are taken care of: no debt, large emergency fund, owns a car, etc.) but since he’s going to school full time and not working, he asked me what his options were. Initially I told him to just wait until he starts working and just continue to save his money in a bank, but he’s eager to start investing now to take advantage of the down market. He has a chunk of money that he doesn’t need in the next five years and wants to put it to work for the long term. Hearing that, I wasn’t sure what he could do or what account he could open.

  12. Jim might have a different opinion of course but I’d go for a diversified low-cost portfolio of funds. Sounds like your cousin isn’t in a high tax bracket so the tax deferral has no juice for him. Does that make sense?


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