Tax-sheltered accounts don’t replace these social jewels. But if you work for a living, or have done so, and want to live reasonably well in the current world, you will want to explore the head-spinning range of tax-sheltered accounts.
Their unfortunate names are often borrowed from the I.R.S. tax code: 401(k), 403(b) and 457 workplace savings accounts, and 529 college savings accounts. Sometimes, they are mainly known by abbreviations — like I.R.A.s and H.S.A.s. (health savings accounts).
And some come in both “traditional” and “Roth” flavors (named after Senator William V. Roth Jr., a Republican from Delaware). The difference is that when you invest in, say, traditional accounts, you can immediately reduce your income taxes that year but will owe taxes later, when you withdraw the money. In Roth accounts, it’s the reverse: You don’t get a tax break for putting money into the account, but you won’t owe tax later.
How They Protect You
Here’s the crucial thing. What all of these tax-sheltered accounts generally do very well is insulate you from taxes on dividends, interest income and capital gains, as long as you hold your investments inside them.
So if you have a choice, try to emphasize tax-efficient funds in taxable accounts. Here’s more jargon: Exchange-traded funds (which can trade on the stock market all day) tend to be better, from a tax standpoint, than traditional mutual funds, Mr. Armour said. Index funds, which merely track markets, are typically more tax efficient than actively managed funds, which tend to trade more frequently. Bond funds and high-dividend stock funds tend to be less tax efficient than simple stock index funds.
All that said, having the resources to locate assets in specific accounts for tax efficiency is a great luxury. “Many people don’t have this choice,” said Joel Dickson, the Vanguard executive who leads the company’s tax planning research.
“Relatively few Americans have large investments in both taxable and tax-sheltered accounts,” he said. Just invest as intelligently as you can, he suggested, and try to emphasize tax-sheltered accounts. Core investment issues — should you own a particular fund, and if so, how much of it — are often more important than tax considerations.