Tax-Free, Tax-Deferred and Taxable Investments

The Taxpayer Relief Act of 1997 has changed the way we look at the investment landscape. The wise way to invest is to keep taxes in the back of your mind so when it comes time to pay them, you don't kick yourself for ignoring them.

Obviously the one investment most of us don't want is the taxable investment, even though they are inescapable. On taxable investments, a gain is treated like regular income that is taxable up to 39.6%. A good example would be actively traded mutual funds that produce short-term gains.

The tax-deffered investments are those you don't have to pay tax on right away, things like 401(k) plans. Under the 401(k) plans, you can let your money appreciate over time tax deferred. You pay taxes on it when you take it out. Another example is the nondeductible IRA under which you can add up to $2000 each year tax deferred until you make a withdrawal, then it's considered regular income.

Tax-free investments are Roth IRA accounts from which the withdrawals are completely tax-free as long as you turn 59 years old. You can withdraw even before that as long as withdrawals are of the money you put into the accounts, not the money that has appreciated over the years. Another good investment is buying a home that you can stay in for two years out of the five years prior to the sale of the house by you. That way when you sell the house, the gains you can make off it are all tax-free. For example, if you bought the house for $125,000 and sold the house six years later for $200,000, you pocket the gain of $75,000 without paying a penny on it to the IRS, given you don't take a lot of deductions on it over the years. Another good example for tax-free investments is mutual funds, especially for those in the higher tax bracket. The gain off these bonds is tax-free.

So keep on the look out for tax-free investments. Try not to make too many taxable investments, but if you have to, try to make them in tax-deferred investments.