This unit discusses different plans for investing money and deferring the taxes on investment earnings until a later date. Tax reduction is not the primary criterion for choosing investments, but it certainly is an important one. Tax-exempt or tax-deferred refers to the tax status of the earnings on an investment. Although these terms sound similar, they are quite different. Understanding how taxes affect different investments will help you to choose the investments that are best for you.
If no taxes are owed on money you earn from an investment, it is in the tax-exempt category (a.k.a. tax-free). An example of a tax-exempt investment is municipal bonds. The interest only (not any capital gains) from these investments is free of federal taxes, as well as state and local taxes, if the investor lives in the state that issued the bond. Another example of a tax-free investment is Roth IRAs if rules to qualify for tax-free withdrawals of earnings are followed. For additional information about tax-exempt securities, refer to Unit 5, Fixed Income Investing.
One of the best ways to save for retirement is through tax-deferred investments. Contributions (money added to an investment plan) to employer retirement plans and some IRAs can be made with pre-tax dollars (i.e., income you don't pay tax on), allowing you to defer taxes until you start making withdrawals. Tax-deferred investing allows you to keep money that would have been paid in taxes at the time you earned the money, leaving a greater amount available for investing.