Calculating the power of tax deferral for you
Do you know the difference between people who are wealthy and people who are not? Of course, the obvious answer is that one group has more money! The wealthy may have acquired their original stake in any number of ways: inheritance, marriage, talent or simply hard work. However, though compounding or reinvesting earnings to accumulate more earnings, an initial sum of money may blossom, especially when tax-deferred financial products are considered.
Conversely, people who are struggling financially often find their situation worsened because they are on the wrong side of compound interest. In many cases, people have to borrow heavily to acquire necessities such as a car or education and the lure of credit cards can be overwhelming. Once the cycle of paying high interest – and interest on interest (compounding in the negative sense) – it is hard to reverse the process. As a general rule, interest is not tax deductible. This, combined with the fact that income earned on many investments is taxed currently, makes accumulating wealth difficult.
Let’s focus on the idea of growing money in a tax-advantaged product. “Tax-deferred” means that money earned in a particular investment is not subject to income tax until it is withdrawn. Examples include IRAs, 401(k) retirement plans, Roth IRAs, 529 college savings plans, and deferred variable annuities to name a few. These products offer an excellent opportunity to help accumulate capital because they can cut your income tax liabilities today, so more of your money remains invested for tomorrow.
For example, $10,000 is set aside for 20 years, earning a hypothetical 8 percent rate of return annually. In one investment, taxes are deferred until the money is withdrawn. In the other investment, taxes are paid annually based on a 30 percent income tax bracket. Withdrawals of the tax-deferred accumulations are subject to ordinary income tax. At the end of 20 years even if all of the money was withdrawn from the tax-deferred product and taxed at the 30 percent rate, it would yield an additional $5,891 in earnings over the investment that was taxed annually. That’s the power of compounding in a product where taxes are deferred! (Note this is a hypothetical example and is not intended to be a projection of future values)
Of course, earnings withdrawn from some tax-deferred products prior to age 59 1/2 may be subject to a 10 percent Federal tax penalty and tax-deferred vehicles (such as variable annuities) have insurance related charges that taxable investments generally do not have.
Tax-free investments also may be important to your long -term financial strategy. “Tax-free” means that earnings from the financial product are exempt from federal, state and/or local income taxes. Municipal bonds and savings bonds are good examples of investments where earnings may be available to you on a tax-free basis. Keep in mind that tax-free municipal bonds may be subject to the alternative minimum tax, and some tax-free investments are subject to state and local taxes.
With the help of a financial advisor, you should develop a personal investment strategy that best suits your tax bracket and investment goals. However, compounding in a tax-advantaged investment may help you achieve those goals in a most effective way.
Jeffrey Apps and Tracy Tutag offer securities and investment advisory services through AXA Advisors LLC (member NASD, SIPC) 1290 Avenue of the Americas, New York, NY 212-314-4600 and offers annuity and insurance products through an insurance brokerage affiliate, AXA Network LLC and its subsidiaries. Call 926.6911 or firstname.lastname@example.org.