Where would you rather invest your money? A Certificate of Deposit (CD) yielding 5% interest that is taxable or a tax-deferred money market account yielding 4% interest. The decision for determining which type of investment is better suited for you is dependent upon your income tax bracket. The decision can be determined by using a simple calculation for an investment. Multiply the interest rate by one minus your tax bracket percentage. An individual in the 15% income tax bracket will need to multiply the interest rate by .85 (i.e.: 1 - .15) while an individual in the 28% income tax bracket will need to multiply the interest rate by .72 (i.e.: 1 - .28) to determine the earnings after taxes. A 5% interest investment will actually earn 4.25% (i.e.: 5 * .85) for an individual in the 15% income tax bracket, while an individual in the 28% tax bracket will actually earn 3.6% (i.e.: 5 * .72). Therefore, an individual in the 28% tax bracket would earn more by placing their money in the tax-deferred money market account earning 4% interest when compared to the taxable CD earning 5% interest due to the tax consequences.
You can also utilize the above calculations to help evaluate IRA, 401(k), mutual fund, and other investment options. Keep in mind that taxes will have to be paid for all tax-deferred investments (except Roth IRA) at the time the money is withdrawn from the account. Until that time, the tax-deferred investment will grow without having to pay taxes each year on any dividends or capital gains received.
Tax-deductible investments provide an opportunity to immediately yield a higher return on an investment and will yield a greater amount of money at the time of withdrawal when compared to a non-tax-deductible investment. Consider an after tax investment of $72 by an individual in the 28% tax bracket. The investment into a mutual fund will be $72 while an investment into a 401(k) will be $100 because taxes will not be paid on the money invested. The result is an immediate return of 38.9% (i.e.: 100 / 72). No investment into a mutual fund will yield that kind of return by simply depositing the funds. An additional advantage to a tax-deductible investment is that more shares of an investment can be purchased than compared to a non-tax-deductible investment. A $25/share investment purchased with $100 will allow the purchase of four shares, while less than three shares will be purchased with $72. The advantage of purchasing more shares is that more money will be earned when dividends or capital gain distributions are paid because the amount paid is based upon the number of shares owned.
A potential disadvantage of a tax-deductible investment is that the investment will be taxed at your income tax bracket at the time the money is withdrawn from an account in the future. Hopefully, your tax bracket at the time of withdrawal will be the same or lower than your tax bracket at the time of the investment. Unfortunately, if your tax bracket is higher at the time of withdrawal, a greater amount of money will be paid in taxes than the amount saved due to the lower tax bracket when initially invested. Another disadvantage for a tax-deductible investment is that the money normally cannot be withdrawn until age 59 1/2 without a penalty, while the mutual fund investment can be withdrawn anytime without a penalty. Although, funds from an IRA and a 401(k) can be withdrawn prior to 59 1/2 only if based on the IRS 72(t) Substantially Equal Periodic Payments calculations. Refer to the IRS web site or an account for further information.
An advantage to a tax-deductible investment is that no taxes will be paid each year on the dividends and/or capital gains received. A non-tax-deductible investment will require taxes to be paid on a yearly basis for the dividends and/or capital gains received (if investment shares are sold).
Carefully decide which option is more beneficial for you or discuss with an investment advisor or a tax professional to determine which investment is better suited for your income tax bracket and goals.
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