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How To Make Smart Tax-Advantaged Investment Decisions

Posted By Guest Contributor On 05/13/2009 @ 1:01 pm In Personal Finance | 14 Comments

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 [3] 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 [4].


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[3] variable annuities: http://wealthpilgrim.com/2009/04/variable-annuities-why-they-stink-how-to-get-out-now/

[4] www.wealthpilgrim.com: http://www.wealthpilgrim.com

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