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Tax-Advantaged, Tax-Free, and Tax-Deferred? Oh my.

Proper diversification, low expenses and consistent investing are some of the keys to long-term financial success, but that’s only part of the picture. Large portfolios can generate large taxes. Keeping what you earn is critical for maximizing your investments. Understanding the big three—tax-advantaged, tax-free, and tax-deferred—is the key to lower overall taxes.

Tax-Advantaged

While the term tax-advantaged sounds specific, in reality, it is an umbrella term for any type of investment account or security that offers the potential of reduced taxes over a similar non-tax-advantaged investment. For example, municipal bonds are tax-advantaged in that the interest they pay is typically free from federal income tax.

There are several types of tax-advantaged accounts and investments. Two of the most common types are tax-free, and tax-deferred.

Tax-Free

Tax-free investments and securities are the Holy Grail of smart tax management. Tax-free, like the name suggests is something that generates no taxes, not now, not ever. In the example above, the interest paid on those muni bonds is not taxable now, or at any time in the future.

A similar example is that of a Roth IRA. Qualified withdrawals from a Roth IRA are tax-free. Such withdrawals are not taxed at all, and they do not increase your taxable income, unlike withdrawals from a tax-deferred investment.

Tax-Deferred

Some of the greatest confusion around smart tax planning comes from the concept of tax-deferral. With a tax-deferred security, or account, taxes are postponed, or deferred. So, while you are not paying taxes each year, those taxes will be paid eventually, usually when you sell, or redeem the tax-deferred investment. The advantage of deferring taxes is two-fold. First, by not using your invested funds to pay taxes, you allow them to remain invested and continue to grow. Second, many people will be in a lower tax bracket during retirement due to no longer working.

For example, many people have a 401(k) or a traditional IRA account, both of which are tax-advantaged accounts offering tax-deferral. The investments inside of such accounts would, in a non-tax-advantaged account, generate several taxable events over their lifetime. Stock dividends and bond interest payments, for example, would be taxable in the year in which they were generated. Likewise, any short- or long-term capital gains would be taxable whenever securities were sold at a profit. However, within both an IRA and a 401(k), such taxable events are deferred. That is, no taxable income is generated in the current year.

However, such gains are not tax-free. Instead, when the account holder withdraws money from the account in retirement, those taxes are due. This is an important distinction, as not only are taxes due on such withdrawals, but they count as taxable income as well, which could potentially push retirees into higher tax brackets, or trigger events such as making Social Security income taxable.

That’s why understanding exactly how your accounts are tax-advantaged is so important.

But even if your investments are not tax-advantaged, you may still be able to benefit from tax deferral strategies. Selling off losing securities before the winners is one way to put off tax exposure. Then there’s tax loss harvesting, which involves selling poorly performing securities in order to realize capital losses that can offset gains—and potentially even some ordinary income. Of course, if your tax bracket is likely to be higher in the future, you may want to think about harvesting gains instead of losses.

Folio Investing has some of the most advanced tax minimization tools in the industry. You can choose from 10 automated tax strategies for selling securities, easily harvest both losses and gains, and even raise cash with no immediate tax consequences. Our state-of-the-art tax lot system gives you tax control all year long.

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