Tax-Deferred investing Matters More Than Ever

Dean Catino for US News World Report writes: There’s an anonymous quote that is very fitting given the new realities of our current tax environment, “I’m putting all my money in taxes — it’s the only sure thing to go up.” Yes, taxes have gone up for many Americans, and it’s my opinion that our politicians will continue with the eternal battle of taxes and spending for years to come.

As we consider taxes in the financial planning and investment world, we always look to minimizes taxes by trying to hold investments for long enough so they qualify for lower tax rates associated with long term capital gain treatment, or by trying to use capital losses to offset capital gains. In the end, there must be a balance in portfolio management – we always want to be aware of taxes, however, we don’t want the “tax-tail” to wag the dog.

The further we look into investment returns, the more we realize that the most attractive account structure for long-term returns is to defer our taxes as long as possible and allow the investor to compound their gains over many years. Some of the most common choices for tax deferred accounts are available through retirement related vehicles offered through our employer. Oftentimes, the employer will match a portion of our deferred contribution, which only adds to the benefit – think of 401(k)s, 403(b)s, and 457(b)s. Even without the employer match there are similar arrangements offered to individuals, including IRAs, Roth IRAs, SEP plans and more. The big take-away is that contributing and investing within a tax deferred account structure is undoubtedly the first logical step that all savvy tax-aware investors should participate in.

We pay “taxes,” but our government refers to them as “revenue.” As such, the government puts limits our contributions in tax deferred retirementaccounts. Take the 401(k) as an example. The annual elective deferral contribution is $17,500 for 2013. (You can contribute an additional “catch-up” deferral of $5,500 if you are 50 or older). Even with the contribution limits, every investor should maximize their contributions into tax deferred accounts. To illustrate the power of the tax deferral and compounding of investment growth, consider the following scenario.

Let’s look at a 50 year old who contributes $39,500 per year into their tax deferred accounts ($23,000 in their 401(k) and $6,500 in their IRA) each year for 20 years and gets a 7 percent annual return. At the end of 20 years, the tax deferred value is 40 percent higher than the taxable value ($1.89 million tax deferred verses $1.35 million taxable). The tax deferred investment account allowed for significant compounding and growth over a long period of time and produced more than $539,000 in additional value!

Clearly, there are significant advantages to tax deferred investments and they should be strongly considered when planning and building an investment portfolio for the long term. Understanding the features, benefits and risks with each investment vehicle is essential to success. With the escalation of tax rates, taking full advantage of the tax deferral is a benefit every investor should exploit.