Nobody likes paying taxes. When it comes to investing, taxes can be one of the most important considerations for someone trying to save for their future goals. There is a strategy to lower your tax exposure and increase your returns substantially by simply knowing the different types of accounts available to investors. I’m going to highlight the concept of tax drag and how an investor can lower their tax burden and increase their annual returns by ~2%.
When you invest in a company retirement plan, such as a 401k, or an individual retirement account (IRA) – you are not taxed on dividends or capital gains while you accumulate your retirement savings. This holds true as well for 529 plans while saving money for college education expenses. These savings enable the value of compounding to work even more so compared to an investor who pays taxes annually on an investment account.
In a non-retirement account or taxable account, investors pay taxes on dividends and capital gains. On average the after-tax return on investments held in a taxable account is 2% less annually than if someone holds these investments in a retirement account. Some investments are also more tax favorable if they are held in certain types of accounts. An example of this would be a high-income investment such as a bond fund that is more tax favorably held in a retirement account because you don’t pay taxes on the income in the retirement account.
Ultimately, the best way to save is as early as possible and often to achieve financial freedom. However, it is also important to consider tax-favorable strategies to further increase your returns. A good financial planner like myself can unlock tremendous value for investors both in the short term by reducing tax liabilities and increasing the cumulative returns investors achieve in the long run.