Taxable, Tax Advantaged, Tax Deferred and Tax Free

Income taxes, though not popular, are an essential part of everyone’s financial life. They are a complicated issue that many simply accept as the norm in America. While the top marginal federal income tax rate has decreased from 70% in the early 1980s to 37% in 2018, almost everyone feels they pay more in taxes than they would like.

And it is not just federal income taxes. Your income is also subject to state, Social Security, and Medicare taxes, and, in some cases, local or city taxes. Overall, many Americans pay between one-fifth and one-half of their income to various government entities.

Be tax-wise, not tax-driven

Making financial decisions solely based on income tax implications is nearly always a bad idea. The key is to understand the tax implications and incorporate them into your decision-making process.

Tax Advantaged

The most common form of tax-advantaged investing uses the favorable income tax rates applied to long-term capital gains on investments held for over a year and to qualifying dividends. The tax rate on long-term capital gains and dividends generally depends on a person’s level of taxable income.

2026 Taxation of Dividends and Long-Term Capital Gains

Tax rate on long-term capital gains and qualifying dividends	Taxable income levels for those filing individual returns	Taxable income levels for those filing joint returns
0%	Up to $44,450	Up to $98,900
15%	$49,451 to $549,450	$98,901 to $613,700
20%	Over $549,451	Over $613,701

Tax Free

The most common way to invest tax-free is by purchasing bonds issued by a municipal, state, or local government agency. Tax laws generally specify that most of these bonds are exempt from federal income taxes. However, they may still be subject to state or local income taxes, so be sure to consult your financial advisor about this. Since interest from these bonds isn’t taxed federally, they often offer lower interest rates compared to other taxable bonds with similar quality and duration. Compare your after-tax returns to see if tax-free bonds are suitable for you.

Tax Deferred

Another less-known but highly effective tax-reduction strategy is to arrange your funds so that taxes on earnings or appreciation are postponed until later. This allows you to keep earning returns on money that would otherwise be paid in taxes. With a tax-deferral strategy, you still owe the tax eventually, but you can choose when that occurs, and the power of compounding results in more money over time.

Two of the most common ways to benefit from income tax deferral are through Individual Retirement Accounts and certain insurance contracts called annuities. Below is an example illustrating this with an IRA.

Example. Robin is 30 years old and wants to save for retirement. In this example, her combined federal and state income tax rates amount to 28% (25% federal and 3% state). She is comparing the benefits of $6,000 annual contributions to a "regular" IRA versus saving $6,000 each year in a bank account.

In this example, let’s set aside any considerations of the deductibility of her IRA contributions and assume a consistent earnings rate of 6% for both the IRA and the bank account. For the IRA option, there are no taxes due annually, but they are payable when the funds are withdrawn. For the bank account, income taxes are paid each year, lowering her after-tax return to roughly 4.3%. The example assumes that contributions to both the IRA and the bank account are made at the end of the year.

The key question is how much money Robin will have at age 60 after taxes are deducted.

Year	Total Contributions	IRA Value	Savings Account Value
1	$6,000	$6,000	$6,000
2	$12,000	$12,360	$12,259
3	$18,000	$19,102	$18,789
4	$24,000	$26,248	$25,600
5	$30,000	$33,823	$32,706
6	$36,000	$41,852	$40,119
7	$42,000	$50,363	$47,852
8	$48,000	$59,385	$55,920
9	$54,000	$68,948	$64,335
10	$60,000	$79,085	$73,115
15	$90,000	$139,656	$123,039
20	$120,000	$220,714	$184,719
30	$180,000	$474,349	$355,075
Taxes Due*		-$82,417	None
Net After Tax		$391,931	$355,075

* Assumes an earnings rate of 6% and that contributions to the IRA were not tax-deductible and therefore taxes are not calculated on the total amount of the non-deductible contributions when received. [($474,349 - $180,000) times 28% assumed combined federal and state tax rates]

As the chart shows, Robin will be nearly $35,000 ahead after paying taxes on distributions by choosing to defer taxes with the IRA option. Tax deferral is a very powerful wealth-building tool.