It’s Whiteboard Wednesday time and we’re in the homestretch of The Investing Series, a beginner’s guide to investing, based on my book, Invest Like a Pro. If you’re just now joining us, you can catch up here.
In the last few weeks, we’ve taken a look at the primary asset classes—stocks, bonds and cash. Today, we turn our attention to investment vehicles (the way a collection of assets is packaged) and how they’re affected by taxes.
Types of Vehicles
There are loads of different investment vehicles to choose from, including 401(k)s, Roth IRAs, traditional IRAs, Keoghs, 403(b)s, and, for federal employees and the military, TSPs—just to name a handful of the ones available in the U.S.
Before you invest, make sure you understand the specifics about the investment vehicle you select. Some involve more paperwork and hassle to invest in, some enforce limits about when you can withdraw your money, tax treatments may differ, and so on.
What About Taxes?
When it comes to the way that your initial investment—not to be confused with your returns—is taxed, you’ve got options. Pay them now, or pay them later (a.k.a., “tax deferred”). This is the biggest consideration when you choose your investment vehicle.
Think of taxes like toll booths on your investment journey. Your money rides along in your selected investment vehicle, which may or may not hit a toll booth (incur a tax). You might even hit several toll booths. For example, with an ordinary mutual fund, you typically pay taxes when you decide to sell your investment. That’s called a capital gains tax.
If you invested in the same mutual fund via an investment vehicle, you could potentially avoid paying taxes if you withdraw from that fund because, in some vehicles, buying and selling assets aren’t taxable events. (As a wise investor, though, you don’t move your dollars around—you only focus on what you can control.)
The returns that you earn on your investment are protected from taxation until you withdraw your money.
Pay Taxes Now, or Later?
A lot of people get hung up on taxes because they want the best deal—should they pay taxes now, or wait until later? If you don’t have a crystal ball, I’m afraid you’re out of luck.
The problem? We only know how taxes affect us in the near-term. Your income (and tax situation) could change significantly over the years. And the tax rate? We just don’t know. Historically, taxes have been as high as 92% and as low as zero! That’s why we don’t worry about the tax rate when we’re analyzing our investments.
At the end of the day, it really doesn’t matter whether you pay taxes now, or later. Once you’ve picked a vehicle, the only question you should ask yourself is, “How much money does my budget allow me to invest?” Then invest as much as possible!
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