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How Do Investment Tax Breaks Actually Work?

With Tax Day right around the corner, we thought it would be a good idea to revisit tax breaks on your investment accounts.  We see too many people out there invested in low return vehicles with high tax rates.  When possible, we obviously want it the other way around: higher return investment vehicles with lower tax rates.

This illustration might be helpful to understand exactly how saving taxes on your investments can help you reach your goals faster.  We often lay out these specific tax shelters for clients in a way that ranks them by tax-efficiency.  For example, which accounts help you keep more of your investment earnings?

If we assume a 24% tax rate and a ~10% investment return, the table might look something like this:

1. 401(k) (and sometimes SEP IRAs and Simple IRAs)

Most everyone knows about 401(k)s, and the potential benefits of the tax break plus an employer match.  In our example, let’s say the employer match is 40% of the employee’s contribution.  Plus, the tax break on the front end in a traditional 401(k) account, or the tax break on the back end in a Roth 401(k) account allows you to keep the rest of your growth.  So, you get to keep 100% of your growth, plus the potential match.  In our example, you’re at a ~14% potential return on your money.

2. Health Savings Account

If used as a long-term investment account, then the return on your assets is equal to that investment return PLUS the tax break you received when you deposited the money.  So, an investor would technically keep all their growth, plus the 24% initial tax break.  In our example, that would be ~12.4%.

3. Roth IRA

This one is pretty straightforward.  If you are eligible to contribute, and if you use the account in accordance with IRS rules, you get to keep all the growth.  We’ll call that ~10% in our example.

4. Joint or Individual Investment Account (commonly called a brokerage account)

Now we get to the point where taxes start eating away at your return.  In this type of account, the best you can typically do is to keep 85% of your investment return on investment sale proceeds.  Let’s call it an ~8.5% after-tax return.

5. Annuities

We usually put annuities last because they are typically taxed at an individual’s highest rate.  This is the ordinary income rate.  In our example, the investor would net only a ~7.4% return.

So, why all this number crunching? Because, as you can see, the return of no. 1 almost doubles that of no. 5.  But, that’s not the worst of it.  After you subtract inflation (say…3%) from these numbers, no. 1 is two and a half times more than no. 5, and twice as much as no. 4.

The point is plain and simple: when your money works harder, you will likely reach your goals faster.  Visit these matters with your investment or tax professional to help ensure you are maximizing your opportunities to shelter your investment growth from taxes.

Got questions?  Contact the Purifoy Wealth Team today!

*This article was written by Michael J. Purifoy, CPA, CFP®, Executive Vice President, Southwestern Investment Group and Wealth Advisor, RJFS

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