To make your portfolio grow as much as it can, it's not enough just to find successful investments. You also have to know how to prevent the IRS from taking away more than its fair share of your profits. With many different rules governing whether your income and gains from investing will be taxable, tax-deferred, or tax-free, finding the best strategy can save you thousands in taxes over the course of your lifetime. It can be tough to compare taxable investments with tax-deferred or tax-free investments, especially when they pay different amounts of interest or offer different growth characteristics. However, this tax calculator can make it much easier to get real comparisons you can use to make the right decision. Let's look more closely at how you can compare taxable, tax-deferred, and tax-free investments more easily.
Choosing investments with different tax attributes
As an investor, you can choose from many different types of investments. Some are fully taxable, meaning that you have to pay taxes on income or gains as soon as you receive them. Others are tax-deferred, which allows you to put off having to pay taxes on income and gains until a later date. And finally, still other investments are tax-free, giving you the opportunity not to pay any tax at all.
You can find the best examples of these three categories in the fixed-income bond investing world. Regular corporate bonds are a good example of fully taxable investments, where the interest the bond pays every six months is immediately subject to tax. Savings bonds, on the other hand, are tax-deferred, allowing you to avoid paying any tax on their appreciated value until you cash them in. Finally, municipal bonds are federally tax-free, and they're also free of state income tax within the state where they were issued.
Inevitably, investments offer different rates of return based on their tax attributes. For instance, as you'd expect, municipal bonds typically pay lower interest rates than corporate bonds of similar maturity, because their interest is tax-free. Savings bonds have no repayment risk because they're obligations of the U.S. government, but their tax-deferred features lead some investors to take lower rates than on regular Treasury bonds that are fully taxable.
An example of how tax attributes make a big difference
In the end, how investments get taxed can cause dramatic differences in their total return. For example, consider an investor in the 28% marginal tax bracket who is considering one of three investments. One is fully taxable and pays a 4% rate of return annually. The second is tax-deferred and offers a 3.5% return. And finally, the last investment is tax-free with a return of 3%. Here's how investing $10,000 in each of these scenarios and waiting 20 years works out, using the calculator above:
- The fully taxable investment initially pays $400 in the first year, but then 28% of that is taken away for tax. Similar treatment occurs throughout the period. After 20 years, the account has grown to $17,645 after taxes.
- The tax-deferred investment grows to $19,898 over the 20-year period, and at that point, tax is collected on the full amount of appreciation. The after-tax amount is actually less, at $17,126.
- The tax-free investment earns less in interest, but the investor gets to keep all of it. At the end of 20 years, the account is worth $18,061.
In this scenario, the tax-free investment does best. But if you use different rates of return, then it will produce different results. Only by using realistic figures based on current market conditions will you get the answers that fit with what's truly available to you.
Some other things to watch out for
In addition, there are a few other factors that play a role. In general, the higher your tax bracket, the more valuable tax deferral or tax-free treatment will be. If you're in a low bracket, however, those tax breaks don't have as much value.
Also, bear in mind that other factors beyond taxes can influence the relative returns that different investments offer. For instance, some municipal bonds pay higher rates of return than Treasuries, even though municipal bonds are tax-free. However, many see muni bonds as having more default risk than Treasuries, and that's something that shows up in interest rate differentials between the two.
Knowing how tax-deferred or tax-free treatment can enhance the value of an investment is crucial. By using the knowledge this calculator can give you, you'll be better able to make smart choices that make your portfolio grow more over time.
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