Don’t Miss Out, You’ll Regret It (Part 5)

Key Points

  • The best way to grow wealth is to never pay any taxes.
  • The simplest way to accomplish this is to take advantage of tax-advantaged investment accounts.
  • The most common such accounts offered by the U.S. Government are the individual retirement accounts or IRAs.
  • There are two flavors. The Traditional IRA is funded with pre-tax contributions, but earnings are taxed at an individual’s marginal tax rate at retirement.
  • The Roth IRA is funded with post-tax contributions, and the earnings are not taxed at all at retirement.   

There Are Ways

Taxes make a big difference over time. As we noted in Part 4, a $10k investment has the potential to grow to about $165k, assuming a 6.4% inflation-adjusted return over 45 years. This is the average 45-year return of the S&P 500 Index since inception. And this also assumes no taxes.

An investor that earns the same 6.4% pre-tax inflation-adjusted return, but ends up turning over his or her portfolio slightly more than once a year will end up paying long-term capital gains each year. In this situation, the investor would only be left with about $95k. But an investor that earns the same 6.4% pre-tax inflation-adjusted return, but ends up turning over his or her portfolio slightly less than once a year will end up paying short-term capital gains each year. In this worst-case situation, the investor would only be left with about $59k. So unless you have some sort of incredible advantage, being a short-term investor has a very steep hurdle cross in order to catch up with a buy-and-hold, and never-pay-tax investor.

So how does an investor never pay taxes? You have to sell at some point right? Turns out, there are some simple solutions to this concern. Let’s explore a few of them in this post.

Ira is Your Friend

The U.S. government has many incentives to encourage individuals and families to save for retirement, and perhaps the most popular are the individual retirement accounts or IRAs. There are two types of IRAs, Traditional and Roth, each with different tax implications. As with taxes in general, it is best to consult with a tax professional about your specific situation, but here are the basics.

First, an account must be funded. A Traditional IRA is funded with pre-tax income, meaning the income used for the initial investment does not get taxed before it goes into a Traditional IRA account. This means that if you want to make a $12,000 contribution into a Traditional IRA account. This happens to be the max contribution for families in 2019. Well, you can take this income that you earned and directly invest it without first having to pay income taxes on it. If your marginal tax rate is 37%, this means a nice 37% savings right off the bat. If you’re planning on saving $12,000 for retirement anyway, this is almost a no-brainer. Free money. You would have to earn $19,048 to be able to invest $12,000 after paying 37% in taxes. But with a Traditional IRA, you just need to earn $12,000. That’s an additional $7,048 in your pocket, just for taking advantage of this government program. It’s hard to think of an easier way to earn $7k, but there you have it.

Another advantage of a Traditional IRA is that your account can grow on a tax-deferred basis. This means you will only have to pay income taxes when you begin to withdraw from this account at retirement. So if you do invest $10k into a Traditional IRA after 45 years, and you manage to earn the 6.4% real return mentioned above, you will have a nice $165k in your retirement account after this period. However, when you begin to withdraw these funds each year after you retire, you will have to pay income taxes on any withdrawals, which again could be as high as 37%. But this tax rate 45 years from now is, of course, subject to your overall income when you retire, and prevailing tax brackets that are set by the government at the time you retire. But still not a bad deal, it seems. So in theory, you would be a very active short-term trader, but you can still get to keep the full $165k and not pay any short-term capital gains along the way. However, there’s still the income taxes you have to pay in the end.

But there’s another option. The Roth IRA is the cousin of the Traditional IRA, and it has a slightly different, but highly impactful nuance when it comes to taxes. It works like this. Instead of being funded with pre-tax income, the Roth IRA is funded with post-tax contributions. This means, assuming you’re in the highest tax bracket, you’ll have to earn $19,048 to invest $12,000 in a Roth IRA (given that you have to pay 37% in taxes first). But the great advantage of a Roth IRA is that after you retire, you can withdraw from your account without ever having to pay any taxes again. This means that if you invest $10k in a Roth IRA, and you end up with the $165k after 45 years, you can effectively spend all of this money and never pay a cent in taxes.

So this is by far the easiest way to grow wealth and not have to worry about tax-man. The great news is that a family can invest $12k each and every year going forward. In the next part of this series, we’ll do some math to see just how much you can save for retirement if you happen to be able to max out your IRA contributions each year.