Only two certain things in life are death and taxes. Really? Are taxes certain? 100% certain? How about I show you how ‘uncertain’ taxes are? Contrary to the popular belief, you can control a lot about taxes. Specifically, you can control the magnitude or the timing or both.
Let us first talk about the magnitude – not all ‘income’ is taxed equally.
Think about it like this – you need $100 every day. If all of it comes from ‘wages’, then simplistically speaking you would need to earn wages of $166. But if the same $100 for your every day needs was coming from capital gains, you would only need capital gains of $125. So capital gains of $125 affords you the same $100 that $166 of wages do.
The above assumes that you are in the top tax bracket, where the wages tax rate is 39.6% and capital gains tax rate is 20%.
(Important note: how did I calculate the exact dollar numbers mentioned above? I used ‘Goal Seek‘ function capabilities within What-if analysis section of Excel – my favorite feature of Excel, a must-learn feature).
Now let us talk about the timing
Ever heard the terms ‘tax deferred’ and ‘tax exempt’? If not, then let us spend a few moments to understand these two terms in plain English. These two words alone can make you ‘retirement-eligible’ at least one full year quicker if not more.
Tax deferred: Tax deferred means earnings (interest, dividends or capital gains) accumulate tax free until you withdraw them. The most common example of a tax deferred account is an Individual Retirement Account (IRA). (We will discuss an example in a few minutes)
Tax exempt: Also known as tax free, these accounts (or investments) are tax free. The most common example of a tax deferred amount is a Roth IRA. Up to applicable limits, you can contribute after tax dollar to your Roth IRA account every year. When you withdraw this money in retirement, there are no taxes 🙂
How does a tax deferred account help? It helps in two ways:
1. The money grows tax free
Let us take an example to understand this: you invest $100 and make 8% the first year and get $6 after tax (assuming a tax rate of 25% tax). The second year, you have $106 to invest ($100 original + $6 additional), you again invest and get a return of $8.48 ($106 * .08 ). You pay $2.12 in taxes (.25 * $8.45). The money that remains after tax with you is $106 + $8.48 – $2.12 = $112.36. So far so good?
Now consider if the money would have grown tax free for two years (at exactly the same rate of return and the same tax rate). In two years, your money becomes $100 * 1.08 * 108 = $116.64. Your earnings are $16.64 before taxes. You pay 25% taxes, so your taxes are $16.64 * .25 = $4.16. The after tax money with you is $116.64 – 4.16 = $112.48. 12 cents more!
In case you are thinking you can afford 12 cents, think again 🙂
$5,000 invested tax deferred every year from the age of 20 till the age of 65 leads to an additional after tax $437,807.
2. The second benefit of tax deferred accounts (investments) is the fact that taxes might be lower at the point in time when money is withdrawn (retirement).
Let us take the same example, you save $5000 every year from age 20 till 65 and make the same 8% return. But now in retirement your tax rate has gone down to 15% in stead of the original 25%. So you now pay 15% on the earnings. This time you will have an additional $208,713 (on top of the earlier additional $437,807) taking your total ‘additional over the regular taxable’ to $646,520.
How does a tax exempt account help? It is a no-brainer that not paying taxes is better than paying taxes, let us take a quantitative example as to how much difference can a Roth IRA make. A person who contributes $5,000 from the age of 20 till 65 has $2,087,130 in his Roth IRA account. If taxes were applicable (if this money was in regular taxable account), then taxes at the rate of 25% equal $521,783. But since this money is in the Roth IRA, you can withdraw it tax free. Yes, you can withdraw all of $2,087,130 without paying any tax on it.
The two worse most common causes of wealth depletion are inflation and taxes. There isn’t much you can do about inflation but there is certainly a lot you can do about taxes. Specifically you can control either the magnitude or timing or both.
(Ok, technically you can protect yourself against inflation using TIPS – Treasury Inflation-Protected Securities. but for the time being let us go with the spirit of this post, I promise to explain TIPS another day).
Most examples above (as well as most other examples I use) are ‘simplistic’ examples used to drive home a point. They ignore additional details that might be applicable to your situation. For example, perhaps a NII (Net Investment Income) tax of 3.8% is applicable to you, in addition to the 20% capital gains tax.
OneMoreDime Special: While I am super crazy about both tax deferred and tax exempt accounts, just remember that there are age limits for withdrawal. For example, as of 2015 you can withdraw from the traditional IRA only after 59 1/2 years of age, otherwise there is a 10% penalty. (Like everything else in the tax code, there are exceptions to the penalty rule too, but that discussion is not for today).
The average man knows as much about the atomic bomb as he does about his income-tax form.