Back when I was in 6th grade (I know, some of you weren't even born yet), my teacher, Mr. Rast, asked me a question about money. He asked me if would rather have $100,000 or start with a penny doubled every day for a month ($0.01, 0.02, 0.04, 0.08, 0.16 and so on). Well I knew $100,000 is a lot of money and I went for it. Boy, was I wrong. The result of the doubling would have yielded $5,369,709.12. Of course, this is America and I wouldn't get to keep it all. The IRS is going to want a cut.
If I assume a 25% tax rate, the Government would take $1.3M of my $5.3M. Ouch. But that assumes that I get to wait until the end to pay the taxes. What if I have to pay taxes along the way? If I pay 25% in taxes on the income each year. I'd "only" have $1.1M at the end of the 30 days. That's right. 25% of the amount I received after tax when I got to defer the taxes. It isn't that I paid $3M in taxes. It is that I lost the compounding on the money that I paid in taxes.
What to Do?
Think about not just what you invest in, but where you put your investments. You have options for tax free tax treatment of earnings, tax deferral or fully taxable accounts. As much as possible you want to avail yourself of tax free and tax deferred accounts.
Specifically, if your investments produce ordinary income (Bond Funds, CDs, Money Markets), put them inside your tax deferred accounts. If your investments produce primary capital gains, then a tax-free account, like a Roth IRA, is a good option.
What should you put in taxable accounts? Assets that produce capital gains and qualified dividends are a good choice as the income has a tax rate that is lower than your marginal tax rate. International Stock Funds and ETFs are especially attractive as they often pass on a Foreign Tax Credit that you can use to offset some of your US tax burden.
There is more to Financial Planning than picking investments. Taxes are a big part of an overall plan and you can greatly increase the amount of money "in your pocket" by properly planning for them.
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