Compounding of earnings and starting to save early have a tremendous positive effect on how much you accumulate for retirement. But to make the most of compounding, you also need to be smart about taxes.If you don’t plan ahead, the federal and state governments could collect a huge portion of your retirement savings. Uncle Sam can take as much as 37%.  When you add in state taxes (if applicable), as well as  phase-out rules that can reduce or eliminate tax breaks as income rises, you could be looking at an effective marginal tax rate of close to 50% or higher.

So the relevant number to watch is the after-tax return — that’s what you get to keep. Here’s a rundown of some of your saving options:

Tax-Deferred Retirement Accounts

As you know, taxes are deferred when you save and invest with a traditional IRA, company-sponsored qualified retirement plan (such as a 401(k) plan), or a self-employed retirement plan (such as a Simplified Employee Pension or Keogh plan). With these tax-deferred accounts, you don’t owe any taxes until you withdraw money. In effect, your tax bill is postponed until you reach retirement age and start taking withdrawals. At that point, you may be in a lower tax bracket.

Saving in a tax-deferred retirement account allows you to take advantage of tax-free compounding for many years. Although you’ll eventually have to pay the tax collector, you’re still better off than if your earnings had been taxed annually. Plus, you can generally deduct your contributions to these accounts.

Tax-Free Roth IRAs

If you qualify to contribute to a Roth IRA, your contributions are not deductible. For most people, this disadvantage is more than offset by the fact that your earnings are allowed to accumulate tax-free (as opposed to just tax-deferred). Specifically, you won’t owe any federal income tax as long as you don’t withdraw any earnings before age 59 1/2. (Also, at least five years must elapse between when you open your initial Roth IRA and when withdrawals commence.)

Taxable Retirement Savings Accounts

When you save and invest via a taxable account (such as an investment account with a brokerage firm), there are two basic federal tax rules to keep in mind:

  • Under current tax law, you pay no more than 20% to the U.S. Treasury on long-term capital gains from selling investments held for over one year. The same rate applies to qualified dividends. The 20% rate only affects singles with taxable income above $425,000, married joint-filing couples with income above $479,000, heads of households with income above $452,400, and married individuals who file separate returns with income above $239,500.
  • Capital gains on investments held less than a year are short-term capital gains and taxed at ordinary income tax rates of 10,12, 22, 24, 32, 35, or 37%.

Thankfully, you can often invest on a largely tax-deferred basis even with a taxable account. How? By buying and holding low-dividend stocks or “tax-efficient” mutual funds. With this strategy, you are only taxed currently on dividend payouts, which can range from nonexistent (with many growth stocks) to minimal (with low-dividend stocks and tax-efficient mutual funds).

The following analysis illustrates how taxes and compounding interact dramatically to affect what you’ll have to finance your retirement. These examples are based on the assumption that you are in the 24%  federal income tax bracket and 5% state tax bracket (for a 29% combined rate). Let’s say you save $10,000 annually, start at age 35, and earn an 8% annual return. At age 60, you would have accumulated:

  1. $526,685 after taxes if your money is in a taxable investment account and you pay taxes each year (8% equates to a 5.68% annual after-tax rate of return). This scenario produces the lowest amount because you get hit with a tax bill each year. This dramatically reduces your annual after-tax rate of return and that negative factor is compounded over the 25-year period.
  2. $544,857 after taxes if your money is in a tax-deferred retirement account (such as a 401(k), Simplified Employee Pension or Keogh plan) and you pay a combined 26% rate for federal and state income taxes at age 60. You can increase this amount substantially if you scrupulously invest the annual tax savings from your deductible retirement account contributions in a taxable investment account.
  3. $736,132 in after-tax money if you put $5,000 annually into a tax-free Roth IRA and $5,000 into a tax-deferred retirement account. (This assumes no state income taxes on Roth earnings, which is currently true in some but not all states.) This scenario produces the greatest after-tax wealth, because you completely avoid taxes on half your earnings.

Conclusion: Never underestimate the power of smart tax strategies to boost the end result of retirement saving. Minimizing taxes makes a big difference in the wealth you can enjoy in retirement.

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