Investing and taxes: Pay now or pay later

Jeff Reeves for USA Today writes: When you think about retirement planning, it's important to remember two powerful factors that matter as much as the dollar amount you save: time and taxes.  Compound interest over the decades can turn even a modest amount of money into a substantial nest egg. And being shrewd with your tax burden can wind up saving you an additional 10% or more of that nest egg when it's time to actually tap your retirement funds.  In most cases, tax-deferred investments like an employer-sponsored 401(k) are a wise choice. Here are the benefits:

Reduce your annual tax burden during your working life. Simply by saving for retirement, you save at tax time. Putting pre-tax money into an employer-sponsored 401(k) reduces your overall taxable income, and contributing to a traditional IRA allows folks to deduct up to $5,000 on their tax returns. These breaks could significantly lower the taxes on your peak earnings years, keeping more of your paycheck in your pocket.

Taxes paid later in life are likely lower. Deferring taxes isn't just kicking the can down the road if you will pay a lower tax rate in retirement. Consider that after hitting 59 years and 6 months, you will pay ordinary income tax rates on what you withdraw from a 401(k) – meaning a single person withdrawing $35,000 from her 401(k) in 2012 was subject to no more than 15% tax on that sum. A top wage earner in 2012 could have paid double that in taxes last year.

Your tax savings fuel compound interest. Perhaps the most tangible benefit of all is that by deferring taxes, you put 100% of your money to work in an investment account so it can grow instead of forfeiting a fraction to taxes. If you save $5,000 annually and get a 5% rate of return on your investments, you'll have almost $350,000 in 30 years. But if you save just $4,000 each year because the IRS is eating up about $1,000 in up-front taxes, you'll have $280,000 in the same time frame and at the same rate of return. And if your rate of return is even higher? Then you leave more money on the table because of paying taxes up front instead of putting that money to work and paying taxes later.

The vast majority of Americans hold traditional IRAs or 401(k) plans because of these very tangible benefits. Of course, there are a few cases when it does make sense to pay taxes on the front end and invest in vehicles such as a Roth IRA or even a brokerage account. Here's when that makes sense:

You're young and proactive. Most people wait until they have good-paying jobs to start planning for retirement. But what if you're 19, working at the mall and making only several thousand dollars annually? Your tax rate is rock bottom – a 10% effective rate according to 2012 tax brackets. In this case, paying taxes up front and opting for a vehicle like a Roth IRA is very wise because there's little chance you'll be able to pay lower taxes down the road. Best of all, Roth IRA withdrawals can be used before retirement to pay for your first home so you have options beyond retirement to tap that nest egg.

You want to spend the money sooner. There are severe penalties for withdrawing tax-deferred retirement funds in your late 40s or early 50s. So if you want to invest with an aim of quitting work early or just want the flexibility to tap into your investment gains for a nice vacation, you may have no choice but to use a taxable brokerage account or other investing options. Conventional retirement plans accommodate only conventional retirement ages.

You have maxed out tax-deferred options. If you want to retire in style, sometimes you'll have to save more than the IRS allows you to write off. As mentioned, a traditional IRA offers most folks a $5,000 cap on deductions. So what if you want to save more than $5,000? You could, of course, plow more into the tax-deferred IRA without a tax benefit. But without that sweetener, the vehicles that make you pay taxes up front may not look as unappealing anymore. Depending on your specific income, tax burden and retirement needs it may make sense to explore multiple investing options.

Remember, the bottom line is that all investment and retirement decisions are intensely personal. Any moves should be based on your specific finances now, your family's goals and any unexpected occurrences life can throw your way across the 20 or 30 years between now and retirement. If you find yourself in a sticky situation with no easy answers, perhaps the best investment you can make is to hire a qualified tax and retirement professional to advise you on the proper course of action.

Sometimes a few hundred bucks spent on a qualified retirement adviser is worth much more than any other investment you can make.