Income Tax Considerations
Taxes can take a big bite out of your total investment returns, so it's helpful to consider tax-advantaged strategies whenever possible (keep in mind, though, that investment decisions shouldn't be driven solely by tax considerations).
For example, retirement plans like 401(k) plans and 403(b) plans allow you to contribute a percentage of your earnings on a pre-tax basis, and funds in the plans aren't taxed until
withdrawn. Other savings vehicles, like Roth 401(k)s and Roth IRAs, are funded with after-tax dollars, but if certain requirements are met, withdrawals are federal income tax free. Note, however, that with all of these plans, a penalty tax applies (in addition to any ordinary income tax due) if you make a withdrawal without satisfying certain conditions (e.g., reaching a minimum age, or satisfying a holding period), unless an exception applies.
For example, retirement plans like 401(k) plans and 403(b) plans allow you to contribute a percentage of your earnings on a pre-tax basis, and funds in the plans aren't taxed until
withdrawn. Other savings vehicles, like Roth 401(k)s and Roth IRAs, are funded with after-tax dollars, but if certain requirements are met, withdrawals are federal income tax free. Note, however, that with all of these plans, a penalty tax applies (in addition to any ordinary income tax due) if you make a withdrawal without satisfying certain conditions (e.g., reaching a minimum age, or satisfying a holding period), unless an exception applies.
How big an effect can income tax have?
Assume two people have $5,000 to invest every year for a period of 30 years.
One person invests in a potentially tax-free account like a Roth 401(k) that
earns exactly 6% per year, and the other person invests in a taxable account
that also earns exactly
6% each year, using
funds from the taxable
account to pay any taxes due each year. Assuming a tax rate of 28%, in 30 years the tax-free account will be worth $395,291, while the taxable account will be worth $295,896. That's a difference of $99,395.
One person invests in a potentially tax-free account like a Roth 401(k) that
earns exactly 6% per year, and the other person invests in a taxable account
that also earns exactly
6% each year, using
funds from the taxable
account to pay any taxes due each year. Assuming a tax rate of 28%, in 30 years the tax-free account will be worth $395,291, while the taxable account will be worth $295,896. That's a difference of $99,395.
This hypothetical example is for illustrative purposes only, and its results are not representative of any specific investment or mix of investments. Actual results will vary. The taxable account balance assumes that earnings are taxed as ordinary income and does not reflect possible lower maximum tax rates on capital gains and dividends which would make the taxable investment return more favorable thereby reducing the difference in performance between the accounts shown. Investment fees and expenses have not been deducted. If they had been, the results would have been lower. You should consider your
personal investment horizon and income tax brackets, both current and anticipated, when making an investment decision as these may further impact the results of the comparison. This illustration assumes a fixed annual rate of return; the rate of return on your actual investment portfolio will be different, and will vary over time, according to actual market performance. This is particularly true for long-term investments. It is important to note that investments offering the potential for higher rates of return also involve a higher degree of risk to principal.
Source : Kramer Financial
personal investment horizon and income tax brackets, both current and anticipated, when making an investment decision as these may further impact the results of the comparison. This illustration assumes a fixed annual rate of return; the rate of return on your actual investment portfolio will be different, and will vary over time, according to actual market performance. This is particularly true for long-term investments. It is important to note that investments offering the potential for higher rates of return also involve a higher degree of risk to principal.
Source : Kramer Financial
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