Tax-free accounts: Understanding nontaxable investments & savings

As you shape a financial strategy to get the most out of your money, tax efficiency is key. Tax-advantaged investments and accounts can be powerful tools to help secure your family's financial future. And while some of those include "tax-later"/tax-deferred vehicles where you make tax-deferred contributions but then are taxed when you take the money out, "tax-never"/tax-exempt accounts let your money grow without any federal income tax on your investment returns—these accounts are considered tax-free.

Also known as tax-exempt or tax-free accounts, "tax-never" accounts use after-tax dollars to fund your qualifying investments, such as putting money in a Roth IRA or paying premiums on permanent life insurance. When you receive distributions from these assets or liquidate them, you get the benefit of not having to pay taxes on your gains, provided certain parameters are met.

These nontaxable accounts represent one of three tax categories. In addition to the "tax never" bucket, there's the "tax now"/taxable category, which includes savings accounts, CDs, mutual funds and stocks. These accounts use after-tax money and incur federal taxes as they grow. In the "tax later" bucket, you'll find many retirement accounts, such as 401(k)s and traditional IRAs, that can help you save on your tax bill now. But you'll pay tax on your distributions in retirement, including taxes on any gains your invested funds have generated.

Incorporating different types of accounts in a diversified portfolio can maximize your tax efficiency, helping you build a stronger financial future.

Different tax-never accounts are geared toward different goals. Here's a look at each one.

• Roth IRA: These individual retirement accounts can be opened independently, without employer sponsorship. You'll take after-tax dollars earned in a given tax year, up to the yearly limit, and deposit them in a Roth IRA. Knowing they'll grow tax-free, and you'll pay no tax when you receive distributions in retirement.
• Roth 401(k): Structured similarly to a Roth IRA, a Roth 401(k) is an employer-sponsored retirement account where you use after-tax salary deferrals to invest and can withdraw during retirement with no federal income tax bill.
• Municipal bonds: Local governments that want to create new projects for public improvements can issue a bond, or a way for you to loan them money with a set rate of return. You pay no federal taxes on their gains when they mature.
• Life insurance with a cash value: Permanent or whole life insurance policies, as opposed to term life insurance, accrue a cash value over time as you hold the policy and continue to keep up with the premiums. If you opt to cash out this value, you typically won't owe federal income taxes on that money.
• Death benefit on a life insurance policy: Similar to the cash value, the payment of a life insurance death benefit is not taxed at the federal or state level, making it a tax-efficient way to leave a legacy for your family or for causes that matter to you.
• Health savings accounts: In this triple-advantaged account, you put pre-tax dollars in now, allow it to grow without taxes and withdraw funds without a tax bill. However, before retirement age, HSA dollars must be spent only on approved qualified medical expenses.

As you decide where to put your money, it's important to consider what tax bracket you're in now and what you expect for the future. If you're in a low tax bracket now but think you'll be paying a bigger percentage of your income in taxes down the road, it might make sense to invest in accounts that are tax now or tax never rather than tax later. But if you're in a high tax bracket now and expect to be in a lower one after retirement, tax-later investments might be appealing.

As you save for retirement, it's also important to remember that it's the earnings on Roth accounts that are tax never, provided it's a qualified distribution. You do pay taxes on the money you use when making contributions to the account. You reap the benefits later by not paying taxes on gains. It's something to keep in mind as you decide between Roth and traditional IRAs.

Also remember that retirement probably isn't your only savings goal. It can be important to diversify your accounts if you need access to your assets earlier for goals such as buying a house or paying for a child's college education.

Nontaxable accounts offer excellent tax advantages and an opportunity to grow your money, but they're just one piece of an overall financial strategy to help you achieve your goals and live your values.

For some families, it makes sense to also incorporate tax-now and tax-later accounts to address the various expenses and income changes over a lifetime. Talk over your options with a Thrivent financial advisor, who can share valuable knowledge personalized to your unique needs, priorities and long-term plan.