I frequently drive from Maryland to New Jersey and there are a few ways to avoid some tolls that make the trip a little bit cheaper. The only reason I take these detours (really only one) is because I get to avoid the tolls, if there were no tolls, the detour wouldn’t make any sense. So why that is then there are people out there who invest in securities that are not-taxed (municipal bonds) in a tax-free account (Roth IRA)? It’s like taking a detour around a toll that isn’t going to be collected yet many Americans make this critical mistake every single day.
Your brokerage accounts can be broken up into three types: taxed, tax-free, and tax-deferred.
- Taxed – These are your typical accounts where your short term capitals gains are taxed at your prevailing tax rate, your long term and dividend interest are taxed at the 15% rate.
- Tax-Deferred – These are your IRA and 401k (or most other retirement vehicles) where you are taxed once disbursements begin, usually near your retirement age. These are taxed at your prevailing tax rate whenever you begin receiving disbursements, hopefully when your rate is lower than it is now.
- Tax-Free – The magical Roth IRA account is an example of a tax-free account where you put in after-tax dollars and the earnings grow tax free. 529 Qualified State Tuition Plans and Coverdell Education Savings Accounts are also accounts where the earnings grow tax free, but must be used for education expenses for your children.
In the world of investing, there are many vehicles in which you can invest your money and have the earnings protected from federal taxes. While you may be interested in the investment’s lower risk, you shouldn’t select one of these options because of its tax-free nature when investing with a tax-free account like a Roth IRA. The yield of the investment is typically lower because they are protected in part from taxes. Here are some examples:
- US Savings Bonds – US Savings bonds are exempt from State and local income taxes and you can defer paying federal taxes on the interest until you cash it in or until it matures. One of the advantages of these bonds is their semi-tax-free nature and to invest in it in a Roth IRA would be a bit silly – you’re avoiding a toll that isn’t being collected.
- Municipal Bonds – Municipal bonds are exempt from federal taxes and sometimes state and local taxes as well.
- Tax-Free Money Market Funds – These are limited but they usually invest in short-term debt instruments from federally tax-exempt groups.
On the other hand, you should be using your tax-free accounts to do any manner of short-term investing if at all possible. The reason is clear — instead of paying the short-term capital gains tax on your earnings, you pay nothing at all. The tradeoff, of course, is that you won’t be able to spend any of your hard earned money until much later – certainly not that afternoon as you would be able to with a regular brokerage account.
All of this information is a no-brainer for most but it’s surprising how many people say “Oh I bought an EE/E bond in my 401(k) because since I won’t see the money for thirty years, I like the safe investment.” It’s egregious how bad a decision that is, especially since the protection from tax requires the funds be spent on education – which would be tied up within the 401(k). But, it stuff like that happens all the time.
What are some of the craziest investment decisions you’ve heard about from your friends?