A question often asked is, “How will taxes affect my financial accounts and retirement?” Not surprisingly, they have a huge impact on the growth and distribution (income) of your retirement. All financial vehicles/instruments/accounts are categorized by how tax treats them. This tends to make sense as taxes are the largest fee we pay in retirement planning or simply saving money in general, an order of magnitude greater than the often-criticized management fee or commission (though those should certainly be minimized whenever possible as well).
As a fee, taxes are an order of magnitude greater than management fees or commissions.
No matter how complicated the financial world may seem, everything you can place your money into can be boiled down to one of three categories (and sometimes a mix of those categories). That’s it. Three possibilities. The end. We imagine this discussion would have been day one of the class on financial literacy and retirement planning in high school (or even college) if it existed. Over the next three segments, we’ll explore what we call The Tax Columns, and show how taxable, tax-deferred, and tax-free/tax-advantaged financial vehicles work with regard to taxes and your future.
The Taxable Column
In this first category, the “taxable” column, we find common vehicles such as:
- Bank accounts
- CDs
- Money-market accounts/Treasury bills
- Stocks (including dividends)
- Bonds
- Mutual funds/ETFs
- Commodities (precious metals)
- Brokerage accounts (taxable, non-retirement)
Pros
In general, each of these instruments are liquid. Easily accessible or convertible to cash. Perhaps this is a good place to create your emergency fund, or short to moderate term (3-5 years) goals that need to be funded, such as a new car, down payment on a home, or that dream vacation to Ireland (stay in a castle for at least one night, so worth it).
Cons
As the name of this category hints, all of these create a current tax liability when gains are realized. For many (most), that occurs every year (ugh); for others, it might occur only every several years. How much will taxes be on the gains or interest generated? For discussion sake, generally 25-33% between federal and state, depending on where you live and the tax bracket you are in.
Yes, most of the time, you’re going to end up paying ordinary income taxes on these types of vehicles (especially interest-bearing vehicles like bonds, CDs, and money-markets), and perhaps in part long-term capital gains taxes on those gains not realized until after a year of holding that particular instrument (such as a stock held for more than a year before selling for a gain). There are exceptions here and there but in general, those are going to be the scenarios you’re looking at.
Why Do I Care?
So, how much does that really affect the growth of your money in these types of vehicles? Let’s look at an exaggerated example to illustrate.
If you had a dollar, and were able to double it 20 times, it would be over $1 million($1,048,576 to be exact). However, if you were to take that same dollar and double it 20 times, but this time withhold, say, 25% (a relatively common combined tax bracket between federal and state) of the gains for taxes along the way, how much would the ending balance be?
Take a guess.
The answer might really shock you.
We typically get guesses of around $750,000, or $500,000. Some get closer by guessing $100,000. The answer?
Roughly $72,000. Yes, from an ending balance of $1,000,000 all the way down to ~$72,000. Just because of 25% taxes on the gains along the way.
But I still got to keep and double 75% of the gain?! How can it be a reduction of over $900,000?
As hard to believe as this is, it is true. Break out Excel and see for yourself. We had to the first time we were introduced to this umpteen million years ago.
What about a 30% combined tax-bracket? Ending balance after 20 doublings of just over $40,000, instead of $1,000,000. What if we were generous and assumed the lower 15% federal long-term capital gains rate and, say, only 5% for state? Ending balance of $127,000.
Ouch. Even a lower tax-bracket of only 20% still sees a reduction in the ending balance of roughly $873,000 assuming the same rate of return.
Another disadvantage, rarely discussed, is that interest or gains from vehicles in this Taxable Column are classified as Provisional Income, and as such, often make your social security income become unnecessarily taxable. That attributes more tax liability to this category than illustrated and needs to be seriously accounted for.
Now, the point isn’t that we’ll see our money double twenty times in our lifetimes (we should be so lucky), and we admitted up front that this is an exaggerated example to illustrate a point. But can you start to sense why you should not save for long-term goals (such as retirement) in the Taxable Column? Taxes are the largest financial or investment fee we pay (many times greater than brokerage or management fees, which should also be minimized where possible). Understanding how taxes affect your money and its future potential growth is paramount to proper retirement planning.
This is also why most people get so excited (prematurely) about the Tax-deferred Column. While there are advantages for tax-deferred vehicles, they are definitely not all rainbows and unicorns.
Read on to Part 2 of “The Tax Columns—How Will Taxes Affect My Retirement?”