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Compound Interest and the Shadow You Can’t Outrun: Compound Taxes

October 15, 2020
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When people set up accounts to save and invest their money, they are planning for two phases of their life: accumulation and distribution. It is a common recommendation that they take advantage of compounding interest—and in many cases, compounding interest can provide a great option for building wealth. However, compounding interest also brings in tax considerations that people should keep in mind when distributing their funds in order to maximize their returns and minimize what they owe every April 15. Qualified plans, some of which are employer-sponsored, are great examples of tax-deferred accounts (401k, 403b, IRA, SEP, are a few). Taking advantage of a pre-tax 401(k) fund (especially if you have the benefit of employer matching), you can reduce your overall taxable income each year to further reduce your taxes owed.

The Benefits of Compound Interest

Finding a tax-deferred account in which to place your money is a great way to grow your wealth in an exponential way.Interest that compounds regularly can add up quickly, providing you returns with every period’s close and those returns are typically reinvested. When you defer paying taxes on your earnings every year, those gains will continue to allow your account to grow. In the first few years, that account will increase at a steady rate, depending on the investments you’ve chosen. Over the years, your account may start to skyrocket as the taxes are deferred each year. While this is a great system, there is another interested party in your investments: the U.S. government.

How to Plan for Taxes on Your Compounded Interest Earnings

There are many reasons why the government is interested in promoting tax-deferred accounts. You make a better investor for the government during accumulation than the government could do on its own. Additionally, the longer they wait for you to pay your taxes, the better their “investments” could be doing. When you do pay your taxes in the distribution phase of your life, it’s expected that you will be in a larger tax bracket. Due to the gains you’ve made, the taxes should be larger and the government gets their due.

 

There are many things that can impact your money, even if it is safely tucked away in a savings account. Inflation, fluctuating rates, account fees, lost opportunities, and the time value of money are all common hurdles people don’t always consider how to overcome. These unrealized losses and eroding forces accumulate with every passing year, serving to dilute or eradicate the bulk of our expected gains.

 

Make the Most of Compounding Interest With Tax-Advantaged Accounts

Though the most commonly considered types of compounding interest accounts are bank savings, brokerage or advisory accounts, or the aforementioned tax-deferred qualified plans, there are also options that can bring about all of the benefits but none of the tax considerations.Investing your money into tax-free vehicles such as Roth IRAs, tax-free bonds, and Whole Life Insurance can be a great way to grow your funds in a hands-off way without being subject to the disadvantages of a taxable account.

 

Ultimately, the way you choose to divide up your money will depend on your specific situation, but putting it in the most optimal accounts possible can lead to a serious return on investment as you progress through life. A qualified financial advisor can help you determine exactly how your funds can be most advantageously allocated—contact us today to learn more.

 

 

This material contains the current opinions of the author but not necessarily those of Guardian or its subsidiaries and such opinions are subject to change without notice.  Material discussed is meant for general informational purposes only and is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice. Links to external sites are provided for your convenience in locating related information and services. Guardian, its subsidiaries, agents, and employees expressly disclaim any responsibility for and do not maintain, control, recommend, or endorse third-party sites, organizations, products, or services, and make no representation as to the completeness, suitability, or quality thereof.

 

Michael Steven Huskey is affiliated with Consolidated Planning. He is a Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). OSJ: 4201 Congress St., Ste. 295, Charlotte, NC 28209; 704.552.8507. Securities products offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is a wholly-owned subsidiary of Guardian. Consolidated Planning is not an affiliate or subsidiary of PAS or Guardian. 2020-105978 Exp 07/22