EBONY HAZELEGER: Why investment risks and taxes kill your wealth

When it comes to taxes, the truth lies in the fact that they cause the greatest reduction in your investable income. Why? Because some taxes are due when you sell your investments at a profit, while other taxes are due when your investments pay you a distribution. That’s why I urge my clients to use tax-deferred vehicles, whenever possible.

To give you an idea of just how much taxes bleed into your efforts to generate significant wealth, consider the following:

If you double a penny every day for 30 days, you generate the unbelievable amount of $5,368,709.12. But let’s say that you paid 28 percent in income taxes every day that penny doubles. You’ll end up with a paltry of $48,714.41. This goes to show you that having a tax-deferred retirement account can give you a voluminous amount of long-term wealth.

Let me provide another example with predictable timeframes. If you invest $100 per month ($3.33 per day) for 35 years, tax-deferred at 10 percent, you will have $382,827.67. However, if you are in the 28 percent income tax bracket, and you pay taxes each year on the accumulation, in the same 35 years, you would have only $190,056.24, or about half the taxed-deferred amount.

Now, here’s the drawback if you invest in the stock market with qualified dividends on stocks and stock mutual funds. What are qualified dividends? Qualified dividends are qualified for special tax treatment as long as you hold the investment for more than 60 days and are common stocks of U.S. corporations. There are also stocks that are traded through the American Depositary Receipts, which also may be qualified and are based on stocks from foreign companies.

When it comes to qualified dividends, the earnings you receive from selling the investment at a higher price are known as capital gains. The taxes you pay from selling your investment while earning a profit are called capital gains taxes. So if your stock pays dividends, you must pay income taxes on the payments. According to recent tax law changes, some dividends are subject to be taxed at zero percent, 15 percent or a 20 percent tax rate, depending upon your taxable income rate. However, not all dividends qualify, and tax laws are always subject to change. Dividends that are non-qualified are taxed at your income tax rate.

So, in essence, when you sell an investment at a profit, you will get taxed. If you sell within the first year that you own that investment, you may pay taxes as high as 35 percent. However, the tax code encourages longer-term investments to shelter you from paying high taxes. So if you hold onto your investment longer than a year, depending upon your income tax rate, you will pay the rate of either 15 percent or 20 percent for most stocks and funds. In addition, you’ll also pay capital gains tax on some mutual fund distributions, even if you don’t sell shares of the fund.

When the fund itself sells some of its holdings, the taxable gains are passed on to you. Wouldn’t it make sense if you can reposition your money so that you do not lose money on your capital gains? Or are you willing to accept the tax consequences of your stock investments?

Thus, there is no question that tax-deferred investments offer better accumulation on your money, but you still will need to pay taxes that will reduce your real returns. But if your tax-deferred investment also offers tax-free income, you could then have an annual income during retirement “tax-free.” That’s a significant difference.

There are many investments that offer the advantage of taxed-deferred accumulation: A 401K, traditional IRA, savings bonds, annuities, TSA, as well as qualified pension plans. However, there are only two investments that offer both tax-deferral and tax-free income: a Roth IRA and a no-risk tax-free investment vehicle. If investing in the stock market doesn’t fit into your overall investment strategy, then give my office a call today. I can show you how to save a little more and hold on to your investments for longer “tax-free.”

Ebony Hazeleger is the owner and creator of Home Plan Advisors, which specializes in helping families become debt-free, maximize savings for college expenses and retirement, and establish emergency funds while minimizing risk and income taxes based on her smart money management system. For more information, call (866) 248-1871 or visit www.homeplanadvisors.com.