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Money Management Center
Michael Flannelly Nov 10, 2014
Let’s face it, it’s not smart to save money by stuffing cash under a mattress. After all, that cash ends up becoming less valuable over time due to inflation. Furthermore, you are not able to take advantage of interest and investment returns that could multiply your wealth by saving in a variety of savings and investment accounts. But that’s not the end of the story; to fully see an increase in potential savings, you should look to store money in tax-advantaged savings accounts or invest in bonds in order to lower your tax obligations each year.
There are many benefits when it comes to setting up a retirement savings account, as the government allows different tax-advantaged accounts that ultimately benefit individuals. In the eyes of the government, if individuals are able to save enough money for a peaceful retirement without relying on too much government-funded assistance, then it is the best possible outcome for all taxpayers. As such, there are a variety of tax-advantaged accounts that individuals can use to help build wealth and minimize tax burdens. For one, look to individual retirement accounts (IRAs) as a way to save over the long haul. For an in-depth outline of IRAs, check out Dividend.com’s IRA Guide.
Depending on what type of IRA an individual decides to invest in, there are different types tax benefits. In a traditional IRA, the earned income you deposit into the account is tax-deductible. This may be attractive for individuals seeking additional deductions come tax season. However, when you eventually withdraw funds, the money is taxed as normal income. In a Roth IRA, the roles are reversed; the contributions into the account are not tax-deductible, but the eventual withdrawals are tax free.
While traditional and Roth IRAs get the most attention from the personal financial industry, there are other types of accounts to take into consideration as well. First, self-employed individuals and small businesses can look to the simplified employee pension IRA (SEP IRA) as a way to benefit from tax-advantaged retirement savings. Moreover, small business owners can set up SIMPLE IRAs in order to benefit from a tax deduction from contributions. These accounts have a variety of nuances and there are limits to the amount of money you can contribute into the account, so discussing the details with a financial advisor is the best bet for individuals.
When it comes to larger employers, the companies may offer employees certain tax-advantaged retirement accounts as well, with the added benefit of matched contributions. These retirement accounts, the 401(k) and 403, offer some of the same tax-advantages of IRAs. The problem with these accounts, however, is that either employers don’t always offer them or employees do not take advantage of the retirement accounts. For more information on 401(k)s, check out A Simple Guide to Understanding 401(k)s.
A disadvantage of these retirement accounts, like many tax-advantaged savings accounts in general, is that there are stipulations to when and how you can withdraw from the accounts. For the most part, these retirement accounts do not allow individuals to withdraw penalty-free until the age of 59.5. Though there are exceptions to this rule, typically an individual will be hit with a 10% fee plus taxes if withdrawn before the stated age. So while these accounts offer tax-advantages to help accumulate retirement wealth, the money contributed is basically locked in, unless you’re willing to pay a hefty penalty fee.
Saving for retirement is important, but it isn’t the only long-term expense that the government sees fit to give tax advantages. Education is an important area that individuals need to save to pay for, so the government offers tax benefits for individuals seeking an education savings account. There are a number of education savings accounts that parents, grandparents, or others can invest money in to help cover educational expenses down the road for children. The two big education savings accounts are the Coverdell Education Savings Account and the 529 savings plan.
In a Coverdell Education Savings Account, there is a $2,000 per year maximum contribution allowed into the account. The money contributed into the account can be invested in a variety of different assets, like stocks, bonds and mutual funds, and those assets can grow tax-deferred. This can allow investors to take advantage of investing in dividend paying stocks without incurring the taxes on dividends, and reinvesting them to further accumulate wealth. For more on how to take advantage of reinvesting dividends to accumulate savings, check out The Pros and Cons of Compound Interest.
The money invested and accumulated in a Coverdell ESA must be used to pay educational expenses by the time the beneficiary is 30 years old. An advantage is that the money withdrawn can be tax free if it goes to qualified elementary or secondary school expenses, not just college.
A 529 savings plan, on the other hand, only allows for tax-free distributions to pay for qualified college and university expenses, though they do have some similarities to a Coverdell ESA. For one, the money invested in the account grows tax deferred. However, a 529 only allows for a certain choice of state-run investment options. When it comes to total contributions, 529s have a leg up on Coverdells as they allow for unlimited contributions.
Finally, the government also allows for tax-advantaged savings for health care expenses. Again, like education and retirement, the government allows for tax-benefits for those savings for health related expenses because it ultimately cuts down on publicly funded health expenses. The two major health savings accounts in this area are the Health Savings Account and Flexible Spending Account.
The Heath Savings Account is created for individuals covered under high-deductible health plans. It is set up to help pay for medical expenses that those high-deductible health plans may not cover. To be eligible for an HSA an individual may not be enrolled in Medicare or be listed as a dependent on another person’s tax return.
Health Savings Accounts allow for a limited contribution each year that can be invested tax-free to help pay for medical expenses. In 2014, an individual can contribute up to $3,300 to a HSA. The withdrawals can be distributed tax-free as well, if they will be used to pay for a qualified medical expense.
A Flexible Spending Account differs from an HSA in that it is set up by an employer for an employee in order to help pay for qualified expenses, like medical expenses or dependent care expenses. Employees can contribute a portion of earnings into the account without being hit by payroll taxes, which can result in significant payroll tax savings.
Like most accounts, there are some restrictions and disadvantages to a Flexible Spending Account. First, there are limits on how much an individual can contribute each year, which are set by the employer. Also, the employee must use the allocated funds by the end of the plan’s year, or else lose out on the money completely.
Another option that investors have are tax deferred savings accounts. They don’t have the same kind of excitement that investors sometimes look for, but when the markets start to drop, savings bonds can be quite appealing. Even though bonds won’t give you the returns of a good dividend-investing portfolio, bonds do have a place in many portfolios.
What Are Bonds?
Bonds are essentially a loan that you make to a government or company in exchange for a small amount of interest paid back to you in annual or semi-annual installments. Interest rates vary for each type of bond, and there is a loan-term (maturity period) that is established. This means that your bonds will mature at some point, and you will be paid a specified amount according to the interest—or coupon—rate of the bond.
Coupon rates specify how much interest you can count on getting back when you buy a bond, and the maturation period tells you how long you must own the bond to receive the full return on your investment. Because these rates will be stable for the entire maturity period, the income you receive is a sure-thing (as long as the country or company you are buying the bonds from is not risky), so bonds are under the category of fixed-income securities.
There are also differences in what you pay for a bond versus what you will receive once the bond matures. For this reason, there is the bond price (what you pay for the bond), and “par value,” “face value” or “principal” that you receive once the bond matures. Depending on a bond’s desirability, it can be sold at a discount or a premium in the open market. Because of this, you can get a $1000 bond for $800, if the bond is not as desirable, or you can pay $1200 for the $1000 bond, if the bond is very desirable. The price of a bond will be affected by interest rates (if rates rise, bonds are worth less, and if they fall bonds are worth more) and the company or country’s stability and bond rating.
As an example, let’s say you bought a $1000 bond with a coupon rate of 5% and a maturity of 10 years. This means that you will receive 5% interest—or $50—each year that you leave your money in this bond. Bonds usually pay semi-annually, so you will actually be getting $25 every six months for 10 years. When your bond matures after 10 years, you will get your $1000 back, and you will have received $500 in interest payments.
The advantages of bonds are that they offer security and none of the fluctuation that exists in the investing markets. You can imagine if you had $1 million worth of bonds that paid a 7% coupon rate, you’d be making $70,000 per year in interest.
Like companies, bonds have ratings given to them by the major ratings companies (Moody’s, Standards and Poor, Fitch). When investing in bonds, you need to check these ratings to make sure that your investment will provide you with the stability that bonds are known for. If you buy corporate bonds from an unstable company, or bonds from a nation on the brink of bankruptcy, you will no longer have the peace of mind that bonds are supposed to bring.
Advantages and Disadvantages of Bonds
Aside from the advantages of consistency and stability, bonds also offer the advantage of being more secure when it comes to a company or country going bankrupt. Since bonds represent owning the debt of a company or country, bondholders are essentially creditors and, as such, they have a stronger claim to being paid when a company or country declares bankruptcy.
The main disadvantage of bonds is that the returns they offer are historically lower than if you invested your money in the markets. There’s a price to pay for the security and consistency that bonds offer, and that price comes in the form of lower returns on your investment. The other main disadvantage of savings bonds is that they don’t account for rising interest rates or inflation. If you own a bond that pays 5%, and inflation is 2%, your actual return on that bond is less than 5%; if interest rates rise, it also means your bond is less desirable than it once was. If you can put your money in a high-interest savings account, with the flexibility of withdrawing and adding to it whenever you want, at an interest rate of 4%, is it worth the extra 1% to hold a bond and have to adhere to the maturity date?
When Bonds Make Sense
Because the key advantage of bonds is that they are stable, fixed-income investments, they make the most sense when you need an investment that you can plan on. This makes bonds a great choice for your retirement portfolio. Though having dividend-paying stocks in your retirement portfolio is also something we recommend, the closer you get to retirement, the more you will need the stability that bonds offer. It’s generally advised that you rebalance your portfolio twice per year, and the closer you get to your retirement years, the larger weighting you should put on bonds.
Investors seeking tax friendly options for their money may want to try one of the options mentioned above. Although there are restrictions on these different accounts and investments, they may be a good option depending on your specific investment objectives.
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