Compound interest is the earning of interest on interest. In other words, an investor earns money, not just on the amount of their original investment (principal), but on the interest that the principal earned previously. Mathematical genius Albert Einstein is reported to have stated that compound interest is the 8th wonder of the world because its effects are so powerful.
Compound interest works best when income taxes are eliminated, reduced, or deferred, and when investment expenses are kept to a minimum. High income taxes and high expenses reduce investment performance. The loss of investment earnings to taxes and fees is especially painful during market downturns when investors are earning little, if anything, on their investments.
Tax-exempt investments usually provide a greater return to investors above the 10% and 15% federal tax brackets. To determine your marginal tax bracket, based on taxable income and tax filing status, consult the tax tables in your annual income tax form mailing from the IRS or visit the Web site www.rce.rutgers.edu/money2000 and click on “Resources” and “Tax Information” or visit the IRS Web site: www.irs.gov.
Timing is everything when it comes to compound interest. Investments held for more than a year are eligible to take advantage of favorable long-term capital gains tax rates. The timing of a tax-advantaged investment also affects the amount that accumulates. Individual Retirement Account (IRA) contributions, for example, can be made on the first business day of each year up until April 15 of the following year. Over a 20 year period, a hypothetical investor investing early in the tax year will have tens of thousands of dollars more than someone else who waits until the deadline of April 15 fifteen months later.
Another area where investors should pay particular attention is investment expenses. Costs matter, especially over time. According to the Vanguard Group investment firm, a hypothetical investor in a low-cost mutual fund with a 0.2% (one fifth of one percent) expense ratio (expenses as a percentage of fund assets) would have $31,701 more after 20 years than another investor in a fund charging 1.3%, on a hypothetical $25,000 investment earning 10%.
The average expense ratio for mutual funds is about 1.4% ($14.00 per $1,000 of assets). Many investors are paying more than this, however, particularly for mutual funds that charge a 12b-1 fee of up to 1% of assets for marketing and distribution expenses. Tax efficiency also matters. While investors can’t control investment performance, they can select tax-efficient mutual funds (e.g., many index funds) that minimize the expenses and taxable distributions that are passed on to investors.
Review the list below to determine whether or not you are taking advantage of available tax breaks that can result in decreased income taxes and increased retirement savings. The more strategies that you check off, the more savvy you are as a tax-advantaged investor.
1. Participate in a tax-deferred employer retirement savings plan (e.g., 401(k)or 403(b) plan) 2. Contribute at least the percentage of pay (e.g., 6%) required to earn the maximum match from your employer 3. Take advantage of additional employer savings plan catch-up contributions for workers age 50 and over 4. Fully fund an IRA for yourself with earned income 5. Fully fund an IRA for your spouse (whether or not spouse is employed) 6. Take advantage of IRA catch-up contributions for workers age 50 and over 7. Invest in a tax-deferred plan for self-employed persons (e.g., SEP, Keogh) 8. Hold investments for more than a year to take advantage of long-term capital gains tax rates
