One of the best ways to grow your money is through investing. When you invest your money, you have a greater chance of growing your wealth over time. However, there are realities that result in an erosion of your real returns over time. Inflation and fees are always present and reduce your overall returns. Taxes represent another cost that reduces your real investment returns over time.
There is little you can do about inflation, and you can reduce your fees by carefully choosing where you invest, but you can’t eliminate fees altogether. You also can’t completely avoid taxes. But with the right approach, you can reduce the impact of taxes on your returns.
Tax-advantaged retirement accounts exist to help you improve your overall returns for the long run. Here’s why you should invest:
Tax-Deferred Growth
The money you invest before you are required to pay taxes on it grows more efficiently than the money you invest after taxes. You have more money to invest before taxes, and more money means a greater chance of returns.
Of course, when you use a tax-deferred account like a traditional 401(k) or IRA, you have to pay taxes sometimes. But the hope is that the better returns you earn over years of investing with pre-tax dollars will outweigh the taxes you pay when you withdraw your money and pay taxes on it.
Tax-Free Growth
Another option is to invest in an account that offers tax-free growth. When you invest in these types of accounts, most commonly using a Roth IRA or a Roth 401(k), the earnings you receive aren’t taxed when you withdraw them. The downside, though, is that you are investing with after-tax dollars, which means you might not be able to invest as much money right now because you have to pay taxes first.
The tax savings with a tax-free account come later on if you find yourself in a higher tax bracket. If you are in a higher tax bracket during retirement, or if taxes have gone up since you began investing, it was to your advantage to pay taxes earlier, at a lower rate.
Get Both with the HSA
One of the best tax-advantaged accounts is the Health Savings Account (HSA). The HSA allows you to invest with pre-tax dollars, but the money also grows tax-free. As long as you withdraw the money for use to make qualified health care purchases, you don’t even have to pay taxes on your contributions or your earnings. This can be a great way to save up for health care costs later on down the road. (If you use the money for non-qualified expenses, it is treated as a traditional IRA).
There are restrictions associated with the HSA, though. In order to qualify for this type of account, you need to have a high deductible health insurance plan. But if you can afford this type of plan, your HSA can be a great way to invest without the bother of taxes.
No matter how you invest, you need to consider the tax consequences. Without tax planning, you might be surprised at how small your real returns end up being.