Back when I was in 6th grade my teacher, Mr. Rast, asked me a question about money. He asked me if I would rather have $100,000 or a penny doubled every day for a month ($.01, .02, .04, .08, .16, .32, etc…). Well I was no dummy and I knew $100,000 was a whole lot of money. So of course, I went for the $100,000. Boy, was I wrong. The penny doubled for 30 days would have yielded $5,368,709.12. That’s $5 million plus. Of course, you made $2.5 million in the last day. Mr. Rast showed me a very important lesson about compounded interest. But, he neglected another very important factor…taxes.
If I had to pay taxes on the gain at the end of the 30 days, I would only have $4,026,531.84, over $1 million in taxes (assuming a 25% tax bracket). But here is the kicker, if I was required to pay 25% in taxes each day on the gain of doubling (result: .01, .0175, .0363, 0.05359, etc…) after 30 days I would only have $111,712.922 or forgone profits of $3.9 million. Let me say that again, almost $4 million in lost gains (the government didn’t get that much, it was never earned). So what to do?
To begin with, never make a decision on an investment merely to save taxes. However, with that said, tax efficiency (the idea of arranging you assets to minimize taxes) is worth considering.
You can keep the whole $5 million, in our example above, through tax free investments. You can do this by shielding the investment in a Roth IRA or Roth 401K (though to be honest, you would have needed $.0125 to start the program since you’d be investing after tax dollars). You’ll never pay taxes on those gains. You can also use tax free investments like municipal bonds.
You can put yourself in the $4 million after-tax example by using tax deferred investment accounts such as traditional IRAs, qualified retirement plans, 401Ks, TSP, and other quasi-qualified plans (SEPs, SIMPLE plans) as well as with annuities. You won’t pay any taxes along the way and just owe the taxes when you take the money out.
Finally, you can avoid the $111,000 scenario by considering tax efficiency as you allocate you investments. If you invest in deferred or Roth accounts and taxable accounts, look at where you put each investment. Securities that generate little to no taxable income should be held outside your tax deferred/Roth accounts. Some examples that are good fits for taxable accounts (in order of tax efficiency) are municipal bonds, growth stocks, Exchange Traded Funds (ETF), and index mutual funds. Candidates for sheltering in tax deferred and Roth accounts are corporate bonds, income stocks (those that pay high dividends) and actively managed mutual funds. By arranging your investments with tax efficiency in mind you can minimize the taxes along the way.
Again, it is important to remember that taxes rarely should be your primary consideration when selecting investments. But, it makes a lot of sense to look at how you hold your assets to minimize the tax bit.
