We were recently interviewed for a piece on CBS. We discussed the magic of compounding.

Compounding is at the core of investing.

One of the biggest enemies of compounding is taxes.

Tax-Exempt Accounts
You know, and undoubtedly speak with clients, about the compounding benefits of tax-free accounts including IRAs, 401(k)s, in both their regular and Roth versions. You probably talk about 529s, and HSAs, each of which can be useful for specific purposes.

Wouldn’t it be great if your clients could have unlimited access – put as much as they want – into a tax exempt account? We’ll show you how a little later.

Effect of Taxes
Even though you’ve probably seen this many times before, let’s look again at the effect of taxes on compounding. We’ll examine several different scenarios.

IRA
The standard illustration of an IRA assumes that the person funds it each year, with a certain dollar amount, such as $5000. For example, suppose a person starts at age 25, and invests $5000 a year into his IRA. If the average return is 7.5% compounded (the stock market historically has returned closer to 10%), with no taxes reducing the rate of compounding, by age 65, he’ll have over $1,136,000 in his retirement account.

Compare that to the same scenario, except that he paid only 10% tax on the growth each year. The effect of that low 10% tax rate is to drop his retirement assets at age 65 by $200,000 to $936,000.

And very few investors pay only 10% tax on their investment income.

At a more realistic 20%, the age 65 account value drops all the way to $773,000. That’s a total loss of over 30%, even though the tax was “only” 20%. Why? Compounding.

Lump Sum Investing
Or consider an investor who invests a lump sum, say $1,000,000, from the sale of a business.

Suppose he invests the $1,000,000 for 20 years. We’re going to do the same comparison, assuming a 7.5% return. Without tax, the $1 million grows to $4,247,000 in 20 years.

Again, keeping everything the same, except assuming just a 10% tax on the growth, the value in year 20 is only $3,690,000.

And at a 20% tax rate, that year 20 value drops all the way to $3,200,000.

Index Investing
This kind of tax effect is one of the arguments for index investing. One of the appeals of index investing is that the index doesn’t require much trading, and therefore doesn’t generate a lot of realized gains. This is in general true. But most indexes do pay dividends. In the US, the dividend yield is low, but even so, it creates a significant tax drag.

Outside the US, the dividend yield is somewhat higher, 3% or more in most markets, and the tax drag is higher.

And for bonds, of course, most of the yield is taxable at higher rates. A 5% bond yield may provide an effective yield of  just 3% after taxes.

And muni bonds help a bit, but the markets are fairly efficient, which is why a muni bond might pay only 3% while a taxable bond pays 5%.

Solutions
What if there were a way to invest however you want, trade as much as you want, and not worry about taxes?

That’s what IRAs and retirement plans provide. And that’s a big reason that there’s about $20 trillion in IRAs and 401(k)s.

But what about clients who have maxed out their retirement plans? Is there something they can do?

Long Term Investing
Tax Exempt Trusts allow clients to continue to employ the magic of compounding.

Tax Exempt Trusts are especially beneficial for clients who want to invest long-term, without being forced to pay tax on their investments each year.

Tax Exempt Trusts can be structured so the investors are not forced to pay tax each year on the investments. In other words, the trust can act similarly – actually better than – a retirement plan that allows tax-deferred compounding.

For example, say a client sets up a Tax Exempt Trust, and contributes $5,000 each year to the trust, for twenty years. The value of the assets in the trust grows at 7% per year. Imagine two scenarios. In the first scenario, the client pays the tax, 7% of the beginning balance of the assets in his trust. At the end of 20 years, he has $27,253 in his trust. In the second scenario, the client invests in a tax-exempt trust, and does not pay tax on any of the growth. At the end of 20 years, he has $204,977.

Using the tax-exempt trust, the client saved over $177,000 dollars in twenty years!

What you can do
If you have clients who want to continue to grow their wealth without paying tax on the compounding, the Tax Exempt Trust may be just what they need.

If you’re curious to learn more, click here to request an Advisor Guide. Or, call 703-437-9720 and ask for Connor or Katherine. Or email [email protected].

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