In 1789, Benjamin Franklin famously wrote, “…but in this world, nothing can be said to be certain, except death and taxes.” In the last 225+ years, not much has changed.
But while taxes can rarely be avoided, some of them are easily delayed (deferred) – and should be whenever possible.
Income taxes are one of the biggest factors affecting your ability to reach financial independence – but how can they be so impactful?
Imagine trying to run a marathon, but instead of starting the race at the starting line with everyone else, you have to start another 25% or 33% back from the other runners.
How long would it take you to reach the point where everyone else had started the race in the first place?
By the time you reach the starting line, everyone else is rounding the first bend in the course. This is the impact of paying taxes on your earnings before you even have a chance to invest them!
Again, imagine that you are running a marathon, and every time you run a mile, you have to turn around and go back 25% or even 33% and start again.
How long would it take you to reach the finish line? This is the effect of paying taxes on your earnings each and every year.
Minimize Your Tax Burden
There are many ways to minimize your annual income taxes and smart investors and savers take advantage of every legal opportunity. One of the most important ways to minimize your taxes is to invest your savings in tax-deferred accounts.
There are three big benefits to loading up your savings into tax-deferred accounts.
- You get to start at the starting line with everyone else for the race. What do I mean by this? If you take $1,000 of your hard-earned money and put it into a tax-deferred account, you will actually have the full $1,000 working for you. Conversely, if you take $1,000 of your hard-earned money and pay Uncle Sam $280 of it first and then invest the remaining $720, you are starting behind the pack before the race has even begun!
- In a tax-deferred account, the returns on your investments will grow tax-free until you decide to withdraw them in retirement. Those returns will continue to compound for years or decades. If you had invested that same money in a non-tax-deferred account, then every year, you would pay additional taxes on everything that you made that year. Each year your returns would be chopped by the tax man, significantly reducing the returns on that investment. For example, if you earned 7% in a tax-deferred account, that would be the equivalent of 5% in a normal after-tax account if you were in the 28% tax bracket. Would you rather earn 7% or 5%?
- Any money you contribute to a tax-deferred account is deducted from your total income for the year. Why does this matter? In the U.S., we have a progressive tax system which means you pay a higher rate of tax the more money you make. Depending on many factors, including whether you are filing jointly, etc…, the tax brackets are different, but they go in order from the lowest bracket at 10% to the highest bracket at 39.6%. So, anything you can do to decrease your total taxable income will not only protect your tax-deferred money from taxes, but it may also drop you from a higher tax bracket into a lower tax bracket. Being in a lower tax bracket would obviously save you some taxes on your other income.
Types of Tax Deferred Accounts
If you work for a big company, you likely have access to a 401k. This year, you can invest up to $18,000 a year in your 401k plan and pay no taxes on that income in 2016. Of course, you’ll pay taxes on it later when you withdraw the money, but that’s okay, you’ll see below that it is still a big savings compared to a non-tax-deferred account. If you are 50 or over, then you can contribute an additional $6,000 on top of the $18,000 for a total of $24,000 in 2016. That’s a big deal!
You may also have access to a tax-deferred Health Care Savings Account in which you can invest $3,350 for an individual or $6,750 for a family in 2016. If you are 55 and older, you can even contribute an additional $1,000 as a catch-up contribution for a total of $4,350 for an individual or $7,750 for a family.
Like a 401k, these funds are tax-deductible in the year they were invested and unlike a 401k, if you decide you need the money this year for eligible healthcare expenses, you can use the money this year or whenever you want. Everyone should fully fund a Health Care Spending Account if they have one.
If you don’t have access to a 401k or Health Care Savings Account, you should look into the tax-deferred savings options that may be available to you such as IRA accounts. The annual amount you can save in these accounts depends upon your household income and other factors. Check with an accountant or the IRS website to confirm how much you may be able to invest in an IRA.
Tax-Deferred Savings Compared to Regular Savings
I ran some numbers below to quantify the actual difference between putting your money in a tax-deferred account (labeled “Pre-Tax”) compared to putting your money in a regular account (labeled “Post-Tax”). Here goes.
In this example, you’ll invest $1,000 at the beginning of every year and you’ll receive a 7% simple rate of return on your investment each year. In the “Pre-Tax” column, you will see the balance in your account at the end of each year. After ten years, you’ll have saved $14,784. Not bad.
In the four columns on the right-side of the table, you’ll see what your account balances will be if you invest your money after taxes are paid, depending on which income tax bracket you are currently in. I included the most common brackets that people will find themselves in, ranging from 15% to 33%.
You’ll see that if you are in the 33% tax bracket and you invest your hard-earned $1,000 ($670 after taxes) each year for ten years, at the end you will only have $8,696. How can it be that you have less than you even started with ($10,000 after ten years) when you were making a healthy return on your money each and every year?
The problem is that each year, you only had $670 to invest in the first place, after paying your 33% of taxes. If you would have put that money into a tax-deferred account, you would have been able to invest the whole $1,000.
In a post-tax account, you pay an additional 33% of taxes on your gains every year (not all investment returns are taxed as normal income, but for this example and for simplicity, let’s assume that it is) and again, in the pre-tax account you are able to keep all of your gains and keep them reinvested and compounding from year to year.
Over the course of ten years, the tax-deferred account would have a 70% higher balance than the taxed account ($14,784 vs. $8,696). Now, that’s not completely fair because the tax-deferred account has not been taxed yet. The money is tax-deferred, which means taxes are delayed, but not eliminated.
So, to account for this, I calculated the after-tax impact as well in the row labeled “After Paying Taxes.” Assuming that you withdraw the money after 10 years and are in the same 33% tax bracket, the tax-deferred account still has a 14% higher balance.
The difference is even greater over a longer period of time – like the time horizon you might have for retirement. If you compare the 33% tax bracket account to a tax-deferred account, over the course of 20 years, even after paying taxes, the tax-deferred account will have a 31% higher balance. That is a huge impact!
The benefit of investing in tax-deferred accounts is huge and the penalty for investing in normal after-tax accounts is severe. So what’s a rational person to do? Take every legal avenue to protect your hard-earned income from taxes of course!
Make sure to prioritize the funding of your 401k, IRA, HSA and other tax-deferred accounts first, before your other accounts if you are interested in maximizing your net worth. Once those are maxed-out, you can be flexible with where your remaining dollars should go.
Are you maxing out your tax-deferred savings? What percentage of your savings is going into non-tax-deferred accounts?