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No matter your age, it’s probably a good time to think about getting life insurance. It’s a key step in financial planning, so let’s get to know the two main types – term and permanent – so you can understand which is the right option to protect your loved ones.

First, a crash course in what insurance is: When you purchase a life insurance policy, you make recurring premium payments. Should you die while covered, your policy will pay a lump sum that you’ve selected to the beneficiaries you have designated. It’s an important way to know that if you weren’t around, working hard, your loved ones’ expenses (housing, food, medical care, tuition, etc.) would be covered.

Granted, no one wants to imagine leaving this earth, but buying life insurance can give you tremendous peace of mind.

Types of Life Insurance

Now that the basic concept is clear, let’s take a closer look at the two types of life insurance policies: term and permanent.

Term life insurance offers coverage for a certain amount of time, while permanent life insurance provides coverage for the policyholder’s whole life as long as premiums are paid. (These policies come in a variety of options. We’ll break those down for you in a moment.) There’s no right or wrong type; only a policy that is right for you and your needs. Figuring out which one will be easier once you understand the eight different kinds of life insurance and the needs they were designed to satisfy.

1. Term Life Insurance

Term life insurance, as the name suggests, protects a policyholder for a set amount of time. It pays a death benefit to beneficiaries if the insured person dies within that time frame. Term life insurance coverage usually ranges from 5 to 30 years. Typically, all payments and death benefits are fixed.

There are several reasons why a term life insurance policy might be right for you. Perhaps there is a specific, finite expense that you need to know is covered. For instance, if covering the years of a mortgage or college expenses for loved ones is a priority, term life insurance may make the most sense.

These policies can be helpful for young people too. If, say, you took out hefty student loans that are coming due and your parents co-signed, you might want to buy a life insurance policy. The lump sum could cover that debt in a worst-case scenario.

Another reason to consider term life insurance: It tends to be more affordable. If you don’t need lifelong coverage, a term policy might be an excellent choice that’s usually easier on your budget.

A few variables to be aware of:

•   Term life insurance may be renewable, meaning its term can be extended. This is true “even if the health of the insured (or other factors) would cause him or her to be rejected if he or she applied for a new life insurance policy,” according to the Insurance Information Institute. Renewal of a term policy will probably trigger a premium increase, so it’s important to do the math if you’re buying term insurance while thinking, “I’ll just extend it when it ends.”

•   If you would be comfortable with your coverage declining over time (that is, the lump sum lowering), consider looking into the option known as decreasing term insurance.

💡 Quick Tip: Term life insurance coverage can range from $100K to $8 million. As your life changes, you can increase or decrease your coverage.

2. Whole Life Insurance

Whole life insurance is the most common type of permanent life insurance, which protects policyholders for the duration of their lives.

As long as the premiums are paid, whole life insurance offers a guaranteed death benefit whenever the policyholder passes. In addition to this extended covered versus term life insurance, whole life policies have a cash value component that can grow over the policy’s life.

Here’s how this works: As a policyholder pays the premiums (these are typically fixed), a portion goes toward the cash value, which accumulates over time. We know the terminology used in explaining insurance can get a little complicated at times, so note there’s another way this may be described. You may hear this referred to as your insurance company paying dividends into your cash value account.

This cash value accrues on a tax-deferred basis, meaning you, the policyholder, won’t owe taxes on the earnings as long as the policy stays active. Also worth noting: If you buy this kind of life insurance and need cash, you can take out a loan (with interest being charged) against the policy or withdraw funds. If a loan is unpaid at the time of death, it will lower the death benefit for beneficiaries.

The cash value component and lifelong coverage of this type of life insurance can be pretty darn appealing. And it may be a good fit for funding a trust or supporting a loved one with a disability. However, buying a whole life policy can be pricey; it can be many multiples of the cost of term insurance. It’s definitely a balancing act to determine the coverage you’d like and the price you can pay.

For those who are not hurting in the area of finances, whole life can have another use. A policy can also be used to pay estate taxes for the wealthy. For individuals who have estates that exceed the current estate tax exemption (IRS guideline for 2024) of 13.6 million, the policy can pay the estate taxes when the policyholder dies.

3. Universal Life Insurance

Who doesn’t love having freedom of choice? If you like the kind of protection that a permanent policy offers, there are still more varieties to consider. Let’s zoom in on universal life insurance, which may provide more flexibility than a whole life policy. The cash account that’s connected to your policy typically earns interest, similar to that of a money market. While that may not be a huge plus at this moment, you will probably have your life insurance for a long time, and that interest could really kick in.

What’s more, as the cash value ratchets up, you may be able to alter your premiums. You can put some of the moolah in your cash account towards your monthly payments, which in some situations can really come in handy.

This kind of policy is also sometimes called adjustable life insurance, because you can decide to raise the benefit (the lump sum that goes to your beneficiaries) down the road, provided you pass a medical exam.

4. Variable Life Insurance

Do you have an interest in finance and watch the market pretty closely? We hear you. Variable life insurance could be the right kind of permanent policy for you. In this case, the cash value account can be invested in stocks, bonds, and money market funds. That gives you a good, broad selection and plenty of opportunity to grow your funds more quickly. However, you are going to have more risk this way; if you put your money in a stock that fizzles, you’re going to feel it, and not in a good way. Some policies may guarantee a minimum death benefit, even if the investments are not performing well.

This volatility can play out in other ways. If your investments are performing really well, you can direct some of the proceeds to pay the premiums. But if they are slumping, you might have to increase your premium payment amounts to ensure that the policy’s cash value portion doesn’t fall below the minimum.**

This kind of variable life insurance policy really suits a person who wants a broader range of investment options for the policy’s cash value component. While returns are not guaranteed, the greater range of investments may yield better long-term returns than a whole life insurance policy will.

5. Variable Universal Life Insurance

Variable universal life insurance is another type of a permanent policy, but it’s as flexible as an acrobat. If you like to tinker and tweak things, this may be ideal. Just as the name suggests, it merges some of the most desirable features of variable and universal plans. How precisely does that shake out for you, the potential policyholder? For the cash account aspect of your policy, you have all the rewards (and possible risks) of a variable life insurance policy that you just learned about above. You have a wide array of ways to grow your money, which puts you in control.

The features that are borrowed from the universal life model are the ability to potentially change the death benefit amount. You can also adjust the premium payments. If your cash account is soaring, you can use that money towards your monthly costs…sweet! It’s a nice bonus, especially if funds are tight.

6. Indexed Universal Life Insurance

This is another type of permanent life insurance with a death benefit for your beneficiaries as well as a cash account. You may see it called “IUL.”

In this instance, the cash account earns interest based on how a stock-market index performs. For instance, the money that accrues might be linked to the S&P (Standard & Poor’s) 500 composite price index, which follows the shifts of the 500 biggest companies in America. These policies may offer a minimum guaranteed rate of return, which can be reassuring.

On the other hand, there may be a cap on how high the returns can go. A IUL insurance plan may be a good fit if you are comfortable with more risk than a fixed universal life policy, but don’t want the risk of a variable universal life insurance product.

7. Guaranteed or Simplified Issue Life Insurance

With most life insurance policies, some form of medical underwriting is required. “Underwriting” can be one of those mysterious insurance terms that is often used without explanation. Here’s one aspect of this that you should know about.

Part of the approval process for underwritten policies involves using information from exams, blood tests, and medical history to determine the applicant’s health status, which in turn contributes to the calculated monthly costs of a policy. Underwriting serves an important purpose: It helps policyholders pay premiums that coincide with their health status. If you work hard at staying in excellent health, you are likely to be rewarded for that with lower monthly payments.

However, sometimes insurance buyers don’t want to go through that process. Maybe they have health issues. Or perhaps they don’t want to wait the 45 or 60 days that underwriting often requires before a policy can be issued. With guaranteed or simplified issue life insurance, the steps are streamlined. Applicants may not have to take a medical exam to qualify and approvals come faster.

These policies tend to have lower death benefits (think $10,000, $50,000, or perhaps $250,000 at the very high end) than the other types of life insurance we’ve described. Less medical underwriting also means policies tend to be more expensive. Who might be interested in this kind of insurance? It may be a good option for someone who is older (say, 45-plus), has an underlying medical condition that would usually mean higher insurance rates, or has been rejected for another form of insurance. The coverage may suit the needs of someone looking for insurance really quickly, like the uninsured people who, during the COVID-19 pandemic, wanted to sign up ASAP.

One point to be aware of: Many of these policies have what’s called a graded benefit or a waiting period. This usually means that the beneficiaries only receive the full value of the policy if the insured has had it for over two years. If the policyholder were to die before that time, the payout would be less — perhaps just the value of the premiums that had been paid.

Of the two kinds we’ve mentioned, guaranteed is usually the easiest to qualify for (as the name suggests) but costs somewhat more than the simplified issue variety, which tends to have a few more constraints. You might be deemed past the age they insure or a medical condition might disqualify you.

Worth noting: You may hear these life insurance policies are known as final expense life insurance or burial insurance. As with any simplified issue or guaranteed issue life insurance policies, no medical exam is required. These plans typically have a small death benefit (up to $50,000 in many cases) that is designed to cover funeral costs, medical bills, and perhaps credit card debt at the end of life.

8. Group Life Insurance

Group life insurance is often not something you go out and buy. Typically, it’s a policy that’s offered to you as a benefit by an employer, a trade union, or other organization. If it’s not free, it is usually offered at a low cost (deducted from your payroll), and a higher amount may be available at an affordable rate. Since an employer or entity is buying the coverage for many people at once, there are savings that are passed along to you.

That said, the amount of coverage is likely to be low, perhaps between $20,000 and $50,000, or one or two times your annual salary. Medical exams are usually not required, and the group life insurance will probably be a term rather than permanent policy,

A couple of additional points to note:

•   There may be a waiting period before you are eligible for the insurance. For instance, your employer might stipulate that you have to be a member of the team for a number of months before you can access this benefit.

•   If you leave your job or the group providing coverage, your policy is likely to expire. You may have the option to convert it to an individual plan at a higher premium, if you desire.

Deciding Which Life Insurance Is Best for You

So many factors go into creating that “Eureka!” moment in which you land on the right life insurance policy for you. Your age, health, budget, and particular needs play into that decision.

If you need life insurance only for a certain amount of time, you may want to select a term life insurance policy that dovetails with your needs. Covering a child’s college and postgraduate years is a common scenario. Another is taking out a policy that lasts until your mortgage is paid off, to know your partner would be protected.

A term life insurance policy may also be a good fit for someone who has a limited budget but needs a substantial amount of coverage. Since term policies have a specific coverage window, they are often the more affordable option.

For someone who needs coverage for life and wants a cash accumulation feature, a permanent policy such as whole life insurance might be worth considering. Not only will this policy stay in place for life (as long as the premiums are paid), but the cash value element allows use of the funds to pay premiums or any other purpose.

Permanent life insurance lets you know that, whenever you pass on, funds will be there for your dependents. It can be a great option if you have, say, a loved one who can’t live independently, and you want to know they will have financial coverage. Whole life insurance is typically more expensive than term life insurance, but the premium remains the same for the insured’s life.

In terms of when to buy life insurance, here are a few points to keep in mind:

•   It’s best to apply when you’re young and healthy so you can receive the best rate available.

•   Typically, major life events signal people to buy life insurance. These are moments when you realize someone else is depending on you (and, not to sound crass, your income). It could be when you marry or have a child. It could be when you realize a relative will need long-term caregiving.

•   Even if you are older or have underlying health conditions, there are options available to you. They may not give as high an amount of coverage as other life insurance policies, but they can offer a moderate benefit amount and give you a degree of peace of mind.

💡 Quick Tip: With life insurance, one size does not fit all. Policies can and should be tailored to fit your specific needs.

The Takeaway

Picking out the right life insurance policy can seem complicated, but in truth, the number of choices just reflects how easy it can be to get the right coverage for your needs. There’s truly something for everyone, regardless of your age or budget. Whether you opt for term, permanent, group, or guaranteed issue, you can get the peace of mind and protection that all insurance plans bring.

SoFi has partnered with Ladder to offer competitive term life insurance policies that are quick to set up and easy to understand. Apply in just minutes and get an instant decision. As your circumstances change, you can update or cancel your policy with no fees and no hassles.

Explore your life insurance options with SoFi Protect.

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Coverage and pricing is subject to eligibility and underwriting criteria.
Ladder Insurance Services, LLC (CA license # OK22568; AR license # 3000140372) distributes term life insurance products issued by multiple insurers- for further details see ladderlife.com. All insurance products are governed by the terms set forth in the applicable insurance policy. Each insurer has financial responsibility for its own products.
Ladder, SoFi and SoFi Agency are separate, independent entities and are not responsible for the financial condition, business, or legal obligations of the other, Social Finance, LLC (SoFi) and Social Finance Life Insurance Agency, LLC (SoFi Agency) do not issue, underwrite insurance or pay claims under Ladder Life™ policies. SoFi is compensated by Ladder for each issued term life policy.
SoFi Agency and its affiliates do not guarantee the services of any insurance company.
All services from Ladder Insurance Services, LLC are their own. Once you reach Ladder, SoFi is not involved and has no control over the products or services involved. The Ladder service is limited to documents and does not provide legal advice. Individual circumstances are unique and using documents provided is not a substitute for obtaining legal advice.

Non affiliation: SoFi isn’t affiliated with any of the companies highlighted in this article.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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If you are self-employed or receive income other than a salary or employment wages, you could be responsible for making estimated tax payments.

You might think of these estimated taxes as an advance payment against your expected tax liability for a given year. The IRS requires certain people and businesses to make quarterly estimated tax payments (that is, four times each year).

Not sure if you are required to make estimated tax payments or how much you should pay? Here’s a closer look at this topic, which will cover:

•   What are estimated tax payments?

•   Who needs to make estimated tax payments?

•   What are the pros and cons of estimated tax payments?

•   How do you know how much you owe in estimated taxes?

What Are Estimated Tax Payments?

Estimated tax payments are payments you make to the IRS on income that is not subject to federal withholding. Ordinarily, your employer withholds taxes from your paychecks. Under this system, you pay taxes as you go, and you might get money back (or owe) when you file your tax return, based on how much you paid throughout the year.

So what is an estimated tax payment designed to do? Estimated tax payments are meant to help you keep pace with what you owe so that you don’t end up with a huge tax bill when you file your return. They’re essentially an estimate of how much you might pay in taxes if you were subject to regular withholding, say, by an employer.

Estimated tax payments can apply to different types of income, including:

•   Self-employment income

•   Income from freelancing or gig work (aka a side hustle)

•   Interest and dividends

•   Rental income

•   Unemployment compensation

•   Alimony

•   Capital gains

•   Prizes and awards

If you receive any of those types of income during the year, it’s important to know when you might be on the hook for estimated taxes. That way, you can avoid being caught off-guard during tax season.

💡 Quick Tip: Tired of paying pointless bank fees? When you open a bank account online you often avoid excess charges.

How Do Estimated Tax Payments Work?

Estimated tax payments allow the IRS to collect income tax, as well as self-employment taxes from individuals who are required to make these payments. When you pay estimated taxes, you’re making an educated guess about how much money you’ll owe in taxes for the year.

The IRS keeps track of estimated tax payments as you make them. You’ll also report those payments on your income tax return when you file. The amount you paid in is then used to determine whether you need to pay any additional tax owed, based on your filing status and income, and the deductions or credits you might be eligible for.

Failing to pay estimated taxes on time can trigger tax penalties. You might also pay a penalty for underpaying if the IRS determines that you should have paid a different amount.

Who Needs to Pay Estimated Tax Payments?

Now that you know what an estimated tax payment is, take a closer look at who needs to make them. The IRS establishes some rules about who is liable for estimated tax payments. Generally, you’ll need to pay estimated taxes if:

•   You expect to owe $1,000 or more in taxes when you file your income tax return, after subtracting any withholding you’ve already paid and any refundable credits you’re eligible for.

•   You expect your withholding and refundable credits to be less than the smaller of either 90% of the tax to be shown on your current year tax return or 100% of the tax shown on your prior year return.

•   The tax threshold drops to $500 for corporations.

Examples of individuals and business entities that may be subject to estimated tax payments include:

•   Freelancers

•   Sole proprietors

•   Business partners

•   S-corporations

•   Investors

•   Property owners who collect rental income

•   Ex-spouses who receive alimony payments

•   Contest or sweepstakes winners

Now, who doesn’t have to make estimated tax payments? You may be able to avoid estimated tax payments if your employer is withholding taxes from your pay regularly and you don’t have significant other forms of income (such as a side hustle). The amount the employer withholds is determined by the elections you make on your Form W-4, which you should have filled out when you were hired.

You can also avoid estimated taxes for the current tax year if all three are true:

•   You had no tax liability for the previous tax year

•   You were a U.S. citizen or resident alien for the entire year

•   Your prior tax year spanned a 12-month period

Pros and Cons of Estimated Taxes

Paying taxes can be challenging, and some people may dread preparing for tax season each year. Like anything else, there are some advantages and disadvantages associated with estimated tax payments.

Here are the pros:

•   Making estimated tax payments allows you to spread your tax liability out over the year, versus trying to pay it all at once when you file.

•   Overpaying estimated taxes could result in a larger refund when you file your return, which could be put to good use (such as paying down debt).

•   Estimated tax payments can help you create a realistic budget if you’re setting aside money for taxes on a regular basis.

And now, the cons:

•   Underpaying estimated taxes could result in penalties when you file.

•   Calculating estimated tax payments and scheduling those payments can be time-consuming.

•   Miscalculating estimated tax payments could result in owing more money to the IRS.

Recommended: What Happens If I Miss the Tax Filing Deadline?

Figuring Out How Much Estimated Taxes You Owe

There are a few things you’ll need to know to calculate how much to pay for estimated taxes. Specifically, you’ll need to know your:

•   Expected adjusted gross income (AGI)

•   Taxable income

•   Taxes

•   Deductions

•   Credits

You can use IRS Form 1040 ES to figure your estimated tax. There are also online tax calculators that can do the math for you.

•   If you’re calculating estimated tax payments for the first time, it may be helpful to use your prior year’s tax return as a guide. That can give you an idea of what you typically pay in taxes, based on your income, assuming it’s the same year to year.

•   When calculating estimated tax payments, it’s always better to pay more than less. If you overpay, the IRS can give the difference back to you as a tax refund when you file your return.

•   If you underpay, on the other hand, you might end up having to fork over more money in taxes and penalties.

Paying Your Estimated Taxes

As mentioned, you’ll need to make estimated tax payments four times each year. The due dates are quarterly but they’re not spaced apart in equal increments.

Here’s how the estimated tax payment calendar works for 2024:

Payment	Due Date
First Payment	April 15, 2024
Second Payment	June 17, 2024
Third Payment	September 16, 2024
Fourth Payment	January 15, 2025

Here’s how to pay:

•   You’ll make estimated tax payments directly to the IRS. You can do that online through your IRS account, through the IRS2Go app, or using IRS Direct Pay.

•   You can use a credit card, debit card, or bank account to pay. Note that you might be charged a processing fee to make payments with a credit or debit card.

•   Certain IRS retail locations can also accept cash payments in person.

Keep in mind that if you live in a state that collects income tax, you’ll also need to make estimated tax payments to your state tax agency. State (and any local) quarterly estimated taxes follow the same calendar as federal tax payments. You can check with your state tax agency to determine if estimated tax is required and how to make those payments.

The Takeaway

If you freelance, run a business, or earn interest, dividends, or rental income from investments, you might have to make estimated tax payments. Doing so will help you avoid owing a large payment on Tax Day and possibly incurring penalties. The good news is that once you get into the habit of calculating those payments, tax planning becomes less stressful.

Another way to make your financial life less stressful: Find the right banking partner.

Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.

Better banking is here with SoFi, NerdWallet’s 2024 winner for Best Checking Account Overall.* Enjoy up to 4.60% APY on SoFi Checking and Savings.

FAQ

What happens if I don’t pay estimated taxes?

Failing to pay estimated taxes when you owe them can result in tax penalties. Interest can also accrue on the amount that was due. You can’t eliminate those penalties or interest by overpaying at the next quarterly due date or making one large payment to the IRS at the end of the year. You can appeal the penalty, but you’ll still be responsible for paying any estimated tax due.

What if you haven’t paid enough in estimated tax payments?

Underpaying estimated taxes can result in a tax penalty. The IRS calculates the penalty based on the amount of the underpayment, the period when the underpayment was due and not paid, and the applicable interest rate. You’d have to pay the penalty, along with any additional tax owed, when you file your annual income tax return.

How often do you pay estimated taxes?

The IRS collects estimated taxes quarterly, with the first payment for the current tax year due in April. The remaining payments are due in June, September, and the following January. You could, however, choose to make payments in smaller increments throughout the year as long as you do so by the quarterly deadline.

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SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.60% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.

SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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As the saying goes: It’s not how much you earn, it’s how much you keep. And when you make money from your investments you need to consider the impact taxes might have on your earnings.

Fortunately, there are a range of tax-efficient investment strategies that can help minimize the bite that taxes take out of your returns.

What is tax-efficient investing, and how does it work? By understanding the tax implications of different types of accounts, as well as the types of investments you choose (e.g. stocks, bonds, mutual funds), you can determine the most tax-efficient strategies for your portfolio.

The Importance of Tax-Efficient Investing

Investing comes with an assortment of costs, and the taxes you pay on investing profits can be one of the biggest. By learning how to be a more tax-efficient investor, you may be able to keep more of what you earn.

The Impact of Taxes on Returns

Investment tax rules are complicated. Profits from many stock and bond investments are taxed at the capital gains rate; but some bonds aren’t taxed at all. Qualified dividends are taxed in one way; non-qualified dividends another. Investments in a taxable account are treated differently than those in a tax-advantaged account.

And, of course, there is the process of applying investment losses to gains in order to reduce your taxable gains — a strategy known as tax-loss harvesting.

In addition, the location of your investments — whether you hold them in a taxable account or a tax-advantaged account (where taxes can be deferred, or in some cases avoided) — also has an impact on your returns. In a similar way, you can refocus your charitable giving strategy to be tax efficient as well.

Knowing the ins and outs of investment taxes can help you establish a tax-efficient strategy that makes sense for you.


💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.

Types of Tax-Efficient Accounts

Investment accounts can generally be divided into two categories based on how they’re taxed: taxable and tax-advantaged.

Taxable Accounts

In order to understand tax-deferred and tax-exempt accounts, it helps to first understand taxable accounts, e.g. brokerage accounts. A taxable brokerage account has no special tax benefits, and profits from the securities in these accounts may be taxed according to capital gains rules (unless other rules apply).

Taxable accounts can be opened in the name of an individual or trust, or as a joint account. Money that is deposited into the investment account is post-tax, i.e. income taxes have already been paid or will be paid on those funds (similar to the money you’d put into a checking or savings accounts).

Taxes come into play when you sell investments in the account and make a profit. You may owe taxes on the gains you realize from those investments, as well as earned interest and dividends.

With some securities, like individual stocks, the length of time you’ve held an investment can impact your tax bill. Other investments may generate income or gains that require a different tax treatment.

For example:

•   Capital gains. The tax on an investment gain is called capital gains tax. If an investor buys a stock for $40 and sells it for $50, the $10 is a “realized” gain and will be subject to either short- or long-term capital gains tax, depending on how long the investor held the investment.

   The short-term capital gains rate applies when you’ve held an investment for a year or less, and it’s based on the investor’s personal income tax bracket and filing status — up to 37%.

   The long-term capital gains rate, which is generally 0%, 15%, or 20% (depending on your income), applies when you’ve held an investment for more than a year.

•   Interest. Interest that’s generated by an investment, such as a bond, is typically taxed as ordinary income. In some cases, bonds may be free from state or local taxes (e.g. Treasuries, some municipal bonds).

   But if you sell a bond or bond fund at a profit, short- or long-term capital gains tax could apply.

•   Dividends. Dividends are distributions that may be paid to investors who hold certain dividend stocks. Dividends are generally paid in cash, out of profits and earnings from a corporation — and can be taxed as short- or long-term capital gains within a taxable account.

Recommended: How Do Dividends Work?

But the terms are different when it comes to tax-advantaged accounts.

Tax-Advantaged Accounts

Tax-advantaged accounts fall into two categories, and are generally used for long-term retirement savings.

Tax-Deferred Retirement Accounts

A 401(k), 403(b), traditional IRA, SEP IRA, and Simple IRA fall under the tax-deferred umbrella, a tax structure typical of retirement accounts. They’re considered tax efficient for a couple of reasons.

•   Pre-tax contributions. First, the money you contribute to a tax-deferred account is not subject to income tax; you owe taxes when you withdraw the funds later, e.g. in retirement. Thus the tax is deferred.

This means the amount you contribute to a tax-deferred account for a given year can be deducted from your taxable income, potentially reducing your tax bill for that year.

Speaking hypothetically: If your taxable income for a given year is $100,000, and you’ve contributed $5,000 to a traditional IRA or SEP IRA, you would deduct that contribution and your taxable income would be $95,000. You wouldn’t pay taxes on the money until you withdrew that funds later, likely in retirement.

•   Tax-free growth. The money in a tax-deferred retirement account (e.g. a traditional IRA) grows tax free. Thus you don’t incur any taxes until the money is withdrawn.

•   Potentially lower taxes. By deducting the contribution from your taxable income now, you may avoid paying taxes at your highest marginal tax rate. The idea is that investors’ effective (average) tax rate might be lower in retirement than their highest marginal tax rate while they’re working.

Tax-Exempt Accounts

Typically known as Roth accounts — e.g. a Roth IRA or a Roth 401(k) — allow savers to deposit money that’s already been taxed. These funds, plus any gains, then grow tax free, and qualified withdrawals are also tax free in retirement.

Because contributions to Roth accounts are made post-tax, there is also more flexibility on when the money can be withdrawn. You can withdraw the amount of your contributions tax and penalty free at any time. However earnings on those investments may incur a penalty for early withdrawal, with some exceptions.

Recommended: What Is the Roth IRA 5-Year Rule?

Tax Benefits of College Savings Plans

529 College Savings Plans are a special type of tax-exempt account. The contributions and earnings in these accounts can be withdrawn tax free for qualified education expenses. In some cases you may be able to deduct your contributions from your state taxes, but the rules vary from state to state.

While you can invest the money in these accounts, they are limited in scope so aren’t generally considered one of the broader investment account categories.

Tax-Efficient Accounts Summary

As a quick summary, here are the main account types, their tax structure, and what that means for the types of investments you might hold in each.

•   Generally you want to hold more tax-efficient investments in a taxable account.

•   Conversely, you may want to hold investments that can have a greater tax impact in tax-deferred and tax-exempt accounts, where investments can grow tax free.

Types of Accounts	When Taxes Apply	Investment Implications
Taxable (e.g. brokerage or investment account)	Investors deposit post-tax funds and owe taxes on profits from securities they sell, and from interest and dividends.	Investments with a lower tax impact make sense in a taxable account (e.g. long-term stocks, municipal and Treasury bonds).
Tax-deferred (e.g. 401(k), 403(b), traditional, SEP, and Simple IRAs)	Investors contribute pre-tax money, but owe taxes on withdrawals.	Investments grow tax free until funds are withdrawn, giving investors more tax flexibility when choosing securities.
Tax-exempt (e.g. Roth 401(k), Roth IRA)	Investors deposit post-tax funds, and don’t owe taxes on withdrawals.	These accounts offer the most tax flexibility as investments grow tax free and investors withdraw the money tax free.

The Tradeoffs of Tax-Free Growth

Because of the advantages tax-deferred accounts offer investors, there are restrictions around contribution limits and the timing (and sometimes the purpose) of withdrawals. Taxable accounts are generally free of such restrictions.

•   Contribution limits. The IRS has contribution limits for how much you can save each year in most tax-advantaged accounts. Be sure to know the rules for these accounts, as penalties can apply when you exceed the contribution limits.

•   Income limits. In order to contribute to a Roth IRA, your income must fall below certain limits. (These caps don’t apply to Roth 401(k) accounts, however.)

•   Penalties for early withdrawals. For 401(k) plans and traditional as well as Roth IRAs, there is a 10% penalty if you withdraw money before age 59 ½, with some exceptions.

•   Required withdrawals. Some accounts, such as traditional, SEP, and Simple IRAs require that you withdraw a minimum amount each year after age 72 (or 73 if you turned 72 after Dec. 31, 2022). These are known as required minimum distributions (RMDs).

   The rules governing RMDs are complicated, and these required withdrawals can have a significant impact on your taxable income, so you may want to consult a professional in order to plan this part of your retirement tax plan.

When choosing the location of different investments, be sure to understand the rules and restrictions governing tax-advantaged accounts.

Choosing Tax-Efficient Investments

Next, it is helpful to know that some securities are more tax efficient in their construction, so you can choose the best investments for the type of account that you have.

For example, ETFs are considered to be more tax efficient than mutual funds because they don’t trigger as many taxable events. Investors can trade ETFs shares directly, while mutual fund trades require the fund sponsor to act as a middle man, activating a tax liability.

Here’s a list of some tax-efficient investments:

•   ETFs: These are similar to mutual funds but more tax efficient due to their construction. Also, most ETFs are passive and track an index, and thus tend to be more tax efficient than their actively managed counterparts (this is also true of index mutual funds versus actively managed funds).

•   Treasury bonds: Investors will not pay state or local taxes on interest earned via U.S. Treasury securities, including Treasury bonds. Investors do owe federal tax on Treasury bond interest.

•   Municipal bonds: These are bonds issued by local governments, often to fund municipal buildings or projects. Interest is generally exempt from federal taxes, and state or local taxes if the investor lives within that municipality.

•   Stocks that do not pay dividends: When you sell a non-dividend-paying stock at a profit, you’ll likely be taxed at the long-term capital gains rate, assuming you’ve held it longer than a year. That’s likely lower than the tax you’d pay on ordinary dividends, which are generally taxed as income at your ordinary tax rate.

•   Index funds vs. actively managed funds: Generally speaking, index funds (which are passively managed) have less churn, and lower capital gains. Actively managed funds are the opposite, and may incur higher taxes as a result.

Note that actively trading stocks can have additional tax implications because more frequent trades, specifically those that fall into the short-term capital gain category, incur a higher tax rate on gains.

Typically, tax consequences will vary from person to person. A tax professional can help navigate your specific tax questions.

Estate Planning and Charitable Giving

Another important aspect of tax-efficient investing is adjusting your estate plan and establishing a strategy for charitable bequests. Because both these areas — inheritances and philanthropy — can be extremely complex taxwise, it may be wise to consult with a professional.

Taxes and Estate Planning

There are a number of ways to structure inheritances in a tax-efficient manner, including the use of gifts, trusts, and other vehicles. With a sophisticated estate-planning strategy, taxes can be minimized for the donor as well as the receiver.

For example, while there is a federal estate tax, there is no federal inheritance tax. And only six states tax your inheritance as of 2024 (Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania). Iowa is phasing out their inheritance tax for deaths after 2025.

Yet your heirs may owe capital gains if you bequeath assets that then appreciate. But if you leave stock to your heirs, they can enjoy a step-up in cost basis based on when they inherited the stock, so they’d be taxed on gains from that time, not from the original price at purchase.

Tax Benefits of Charitable Contributions

Tax-efficient charitable giving is possible using a variety of strategies and accounts. For example a charitable remainder trust can reduce the donor’s taxable income, provide a charity with a substantial gift, while also creating tax-free income for the donor.

This is only one example of how charitable gifts can be structured as a win-win on the tax front. Understanding all the options may benefit from professional guidance.


💡 Quick Tip: Newbie investors may be tempted to buy into the market based on recent news headlines or other types of hype. That’s rarely a good idea. Making good choices shouldn’t stem from strong emotions, but a solid investment strategy.

Advanced Tax-Efficient Strategies

It may also be possible to minimize taxes by incorporating a few more strategies as you manage your investments.

Asset Location Considerations

As noted above, one method for minimizing the tax impact on your investments is through the careful practice of asset location. A well-considered combination of taxable, tax-deferred, and tax-exempt accounts can help mitigate the impact of taxes on your investment earnings.

For example, with some investment accounts — such as IRAs and 401(k)s — your tax bracket can have a substantial impact on the tax you’ll pay on withdrawals. Having alternate investments to pull from until your tax bracket is more favorable is a smart move to avoid that excess tax.

Also, with multiple investment accounts, you could potentially pull tax-free retirement income from a Roth IRA, assuming you’re at least 59 ½ and have held the account for at least five years (also known as the 5-year rule). and leave your company-sponsored 401(k) to grow until RMDs kick in.

Having a variety of investments spread across account types gives you an abundance of options for many aspects of your financial plan.

•   Need to cover a sudden large expense? Long-term capital gains are taxed at a significantly lower rate than short-term capital gains, so consider using those funds first.

•   Want to help with tuition costs for a loved one? A 529 can cover qualified education costs at any time, without incurring taxes or a penalty.

•   Planning to leave your heirs an inheritance? Roth IRAs are tax free and transferrable. And because your Roth IRA does not have required distributions (as a traditional IRA would), you can allow the account to grow until you pass it on to your heir(s).

Tax-Loss Harvesting

Within taxable accounts, there may be an additional way to minimize some of the tax bill created by selling profitable investments: tax-loss harvesting. This advanced move involves reducing the taxes from an investment gain with an investment loss.

For example, an investor wants to sell a few investments and the sale would result in $2,000 in capital gains. Tax-loss harvesting rules allow them to sell investments with $2,000 in total capital losses, effectively canceling out the gains. In this scenario, no capital gains taxes would be due for the year.

Note that even though the investor sold the investment at a loss, the “wash sale” rule prevents them from buying back the same investment within 30 days after those losses are realized. This rule prevents people from abusing the ability to deduct capital gain losses, and applies to trades made by the investor, the investor’s spouse, or a company that the investor controls.

Because this strategy involves the forced sale of an investment, many investors choose to replace it with a similar — but not too similar — investment. For example, an investor that sells an S&P 500 index fund to lock in losses could replace it with a similar U.S. stock market fund.

Recommended: What Are the Benefits of Tax Loss Harvesting?

Tax-Loss Carryover

Tax-loss harvesting rules also allow an investor to claim some of that capital loss on their income taxes, further reducing their annual income and potentially minimizing their overall income tax rate. This can be done with up to $3,000 in realized investment losses, or $1,500 if you’re married but filing separately.

Should your capital losses exceed the federal $3,000 max claim limit ($1,500 if you’re married and filing separately), you have the option to carry that loss forward and claim any amounts excess of that $3,000 on your taxes for the following year.

For example, if you have a total of $5,000 in capital losses for this year, by law you can only claim $3,000 of those losses on your taxes. However, due to tax-loss carryover, you are able to claim the remaining $2,000 as a loss on your taxes the following year, in addition to any capital gains losses you happen to experience during that year. This in turn lowers your capital gains income and the amount you may owe in taxes.

Roth IRA Conversions

It’s also possible in some cases to convert a traditional IRA to a Roth IRA. This is a complicated strategy, with pluses and minuses on the tax front.

•   By converting funds from a traditional IRA to a Roth, you will immediately owe taxes on the amount you convert. The conversion amount could also push you into a higher tax bracket; meaning, you’d potentially owe more in taxes.

•   Unlike funding a standard Roth IRA, there is no income limit for doing a Roth conversion, nor is there a cap on how much can be converted.

•   Once the conversion is complete, you would reap the benefits of tax-free withdrawals from the Roth IRA in retirement.

•   According to the 5-year rule, if you’re under age 59 ½ the funds that you convert to a Roth IRA must remain in your account for at least five years or you could be subject to a 10% early withdrawal penalty.

Final Thoughts on Tax-Efficient Investing

Given the impact of investment taxes on your returns, it makes sense to consider all the various means of tax-efficient investing. After all, not only are investment taxes an immediate cost to you, that money can’t be invested for further growth.

Key Strategies Recap

Once you understand the tax rules that govern different types of investment accounts, as well as the tax implications of your investment choices, you’ll be able to create a strategy that minimizes taxes on your investment income for the long term. Ideally, investors should consider having a combination of tax-deferred, tax-exempt, and taxable accounts to increase their tax diversification. To recap:

•   A taxable account (e.g. a standard brokerage account) is flexible. It allows you to invest regardless of your income, age, or other parameters. You can buy and sell securities, and deposit and withdraw money at any time. That said, there are no special tax benefits to these accounts.

•   A tax-deferred account (e.g. 401(k), traditional IRA, SEP IRA, Simple IRA) is more restrictive, but offers tax benefits. You can deduct your contributions from your taxable income, potentially lowering your tax bill, and your investments grow tax free in the account. Your contributions are capped according to IRS rules, however, and you will owe taxes when you withdraw the money.

•   A tax-exempt account (e.g. a Roth IRA or Roth 401(k)) is the most restrictive, with income limits as well as contributions limits. But because you deposit money post-tax, and the money grows tax free in the account, you don’t owe taxes when you withdraw the money in retirement.

Further Learning in Tax-Smart Investing

Being smart about tax planning applies to the present, to educational expenses, to the future (in terms of taxes you could owe in retirement), and to your estate plan and your heirs as well. Maximizing your tax-efficient strategies across the board can make a significant difference over time.

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