There are two separate and parallel paths to investing:

Tax-deferred Investments: this covers investments where there are lock-in periods as to when you can withdraw money, and are more geared towards saving for retirement. These plans enable the participant to put aside money on a tax-deferred basis for retirement. Examples are:

Canada:  Registered Retirement Savings Plans (RRSPs)

India:

• EPF:  Employee Provident Fund (provided through your employer)
• PPF:  Public Provident Fund (individually managed via a bank PPF account with a bank)
• NPS:  National Pension System of the Govt. of India
• POSS:  Post Office Saving Schemes

USA:  Regular and Individual Retirement Accounts (IRAs), 401(k), 457, 403(b) etc.

These are what are called “Defined contribution plans”, unlike Pensions, which are called “Defined benefit plans”.

• Investment amount: the amount that you invest is from pre-tax money, which reduces your current year’s taxable income by that much amount, which in turn reduces the taxes you owe for the year in which this investment is made.
• Investment income: the dividend income is re-invested within the same 401(k) or IRA or such tax-deferred investment account, without having to pay any dividend taxes. Similarly, any capital gains from sales within such accounts is to be re-invested back into any such tax-deferred account without incurring any capital gains tax.
• Withdrawal / Sale of investments: Taxes are only due upon withdrawal after you reach the retirement age as prescribed under the law for such tax-deferred accounts. Any withdrawals before reaching the prescribed (under the law) retirement age are subject to taxes plus a penalty for early withdrawal, which is also prescribed under the law.

At the very minimum, you should take advantage of any Tax-deferred investment plans provided by your employer, like the 401(k) plan, especially if your employer provides matching contributions to the investments you make through such plans. Any such matching contributions your employer makes is considered free money. If such tax-deferred investment option is not provided by your employer, then you could consider the IRA route and your eligibility to open such retirement account, even though it has very low limits in terms of amounts you can save in such a plan.

Taxable Investments: this covers investments where

• Investment amount: the amount that you invest is from after-tax money (like the salary that comes in your bank account, after all deductions by your employer, including tax deductions)
• Investment income: the income, dividend or capital gains on selling of your investment, is reported on your tax return as dividend or capital gains income, and is taxed based on your marginal tax rate and the prevailing dividend and capital gains tax rates under the law.
• Withdrawal / Sale of investments: you can sell your investments any time, and withdraw the money anytime for whatever use you may have or intend for that money. The sale would result in capital gain or loss, and is to be reported as such in your current year’s tax return and taxed accordingly.

Beyond the limits of the tax-deferred plans, you should consider investing in stocks, mutual funds, and ETFs via regular investment accounts with brokerage firms, mutual fund providers, and stock transfer agents which provide direct ownership of stocks with dividend reinvestment plans (DRIPs).

Tax-deferred Investment Accounts: For investing in tax-deferred accounts, please talk with your company’s 401(k) plan provider or with other tax-deferred plan providers like your bank, or with companies like Vanguard, Fidelity, Charles Schwab,  or whoever you are considering to open a tax-deferred investment account with.

Taxable Investment Accounts: For regular taxable investment accounts, let’s discuss how to invest with reasonable costs where possible, and where you can cheaply re-invest your dividends to take advantage of the long-term effect of compounding.

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