I’ve been told that Albert Einstein stated that compound interest was the 8th wonder of the world. My 6th-grade teacher, Mr. Rast, helped demonstrate that to me more than a few years ago. He asked me if I would prefer $100,000 or one penny doubled every day for a month. Well, I was no dummy so I took the $100,000. I should have thought a little bit more about what Mr. Einstein said about compound interest. For, if you take a penny and double it (.01, .02, .04,.08…etc) for 30 days, at the end of the month you have $5,368,709.12. Last time I checked $5M is quite a bit more than $100K. Mr. Rast vividly demonstrated to me the power of compound interest. But he did forget about one thing. Taxes.

Taxes would have significantly reduced the amount of money I would have had available. If I would have had to pay taxes on my earnings at the end of each day the penny would have grown to only $111,712.92. That is right $5.2M less. I wouldn’t have actually paid $5.2M in taxes, but I would have had much less money to “double” each day. This is how ordinary income, like interest, works when held outside of a tax advantaged investment vehicle. Now, if I just had to pay taxes at the end of the doubling I would have kept $4,026,531.84. Or in other words, I would have have a tax bill of about $1.3M. This is how a traditional IRA works. You pay your taxes after you’ve made your earnings. So, you have more money to compound every day.

So far, all you really have is an interesting bar trick. You can see how many of your friends you can convince to take the $100K. But with this knowledge, you can plan and use a concept called tax efficient investing…The 9th Wonder of the World. Tax efficient investing is the idea of arranging your investments so that you minimize the tax burden. Let’s show a couple of examples.

1. The amount of money you can invest is lower than the limits for tax advantaged accounts. In this case you’ll most likely want to invest all your funds in those tax advantaged accounts…with a caveat. If you put an asset that generates substantial capital gains with little to no interest into a tax advantaged account, you may actually increase the taxes owed. Why is that?  Because as of today (and scheduled to end at the end of 2012) long-term capital gains receive special tax treatment and are taxed at a maximum rate of 15%. Distributions from some tax advantaged accounts (TSP, Traditional IRAs) are taxed at ordinary income rates which could be higher than 15%. Your guess is as good as mine as to whether the special treatment of capital gains will continue, but it is worth considering.
2. You can or do invest more money than you can fit into tax advantaged accounts.  You can increase the tax efficiency of your portfolio by investing assets as follows.
1. Income producing assets such as bank deposits, CDs, Money Market Funds, Bonds, Actively Managed Mutual Funds and REITS. Invest these types of assets in tax advantaged funds such as TSP and Traditional IRAs. You will gain tax deferred earnings and since the income is already ordinary income (doesn’t receive any special tax benefit) you will maximize the money in your pocket.
2. Assets that are expected to produce some income and mostly capital gains such as Growth Stocks, Index Mutual Funds, some ETFs. Invest these assets in Roth IRAs. Your income and taxable gains will be taxed at 0% when you withdraw them. If desired, you can also invest the income producing assets listed above in a Roth IRA as well.
3. Assets that are expected to produce virtually no income such as Precious Metals, Passive ETFs, Municipal Bonds (income not taxable). Invest these assets outside the tax advantaged funds. You could invest these assets (except the Municipal Bonds) in either a Traditional IRA or Roth IRA.  But, remember in the case of the Traditional IRA you may actually increase the taxes on your capital gains depending on what the happens with the tax code. I rarely say never, but I can’t think of a situation where I would put Municipal Bonds in a tax advantaged account.

You’ve heard me say this here before. Don’t let the tax tail wag the dog. But, if you don’t take the tax consequences into account when you decide where to invest your money, you risk having less money available when you need it…Tax Efficient Investing matters.

Curt Sheldon, EA is a Fee-Only Financial Planner and Enrolled Agent based in Northern Virginia.  He can be contacted at (703)542-4000, (800)928-1820 or Curt@CLSheldon.com

IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication

The information contained in this blog is for general financial education and should not be construed as individual financial advice.  Please consult your own financial, tax or legal advisor prior to applying any principles discussed here to your own financial situation.