If you’re relatively young, and you’ve only been investing for a few years, you possess an asset that is invaluable and cannot be replaced: time. And the more time you spend contributing to tax-advantaged investments, the better off you may be.
As an investor, time is your ally for two reasons. First, the more time you give to your growth-oriented investments, the greater their growth potential. And second, the effects of market volatility have tended to decrease over time, though, as you no doubt have heard, “past performance is no guarantee of future results.”
Clearly, it pays to put time on your side. And when you’re investing in tax-advantaged vehicles, time becomes an even more critical component of investment success, especially when you’re young and have several decades ahead of you before you retire.
Suppose, for example, that you put $200 per month into an investment on which you paid taxes every year. If you earned a hypothetical 7 percent return on this investment, you’d end up with about $324,000 after 40 years.
But if you put that same $200 per month into a tax-deferred investment, such as a traditional IRA, and you earned that same 7 percent return, you’d wind up with about $513,000 after 40 years.
Of course, once you starting taking withdrawals, presumably when you’re retired, you’ll have to pay taxes on your earnings, so your after-tax accumulation would be about $385,000, assuming you took your IRA in a lump sum (which most people don’t) and also assuming you were in the 25 percent tax bracket. However, by the time you retire, you may be in a lower bracket.
Plus, you have some control over how much you withdraw each year, so you may be able to affect the taxes you’ll have to pay.
Furthermore, depending on your income level, your contributions to a traditional IRA may be tax deductible in the years in which you make the contributions (keep in mind that this hypothetical example is for illustrative purposes only and does not represent a specific investment or investment strategy).
While tax deferral is obviously a nice feature for an investment, tax-free may be even better. So, if you meet the income requirements, you might want to consider investing in a Roth IRA, which provides tax-free earnings withdrawals, provided you’ve had your account for at least five years and you don’t start taking withdrawals until you’re at least 59-1/2.
This means that, in the above example, you’d have accumulated that same $513,000 — but you won’t have to pay taxes on your withdrawals.
Generally speaking, the Roth IRA may make more financial sense for people who are eligible, but if you think you’re going to be in a lower tax bracket when you retire, and your income level permits you to deduct some of your contributions, you may want to consider a traditional IRA.
Consult with your tax advisor for guidance on the most appropriate approach for your situation.
When it comes to building resources for retirement, it’s almost impossible to save and invest “too much.” So take full advantage of both time and tax-advantaged investments.
By putting these investments to work for you, and by keeping them at work, you’ll be putting time on your side as you work toward your financial goals.
• This article was written by Edward Jones for Cyndi Newburn, an Edward Jones financial advisor in Ahwatukee Foothills. Reach her at (480) 460-1149.