Long-term investors have long valued the impact tax deferral can have on their portfolios. Taking advantage of the full range of tax-deferred investment options available can be critical, and sometimes it’s the simplest strategies that have the most impact.
 

The Rule Of 72

The Rule of 72 is a time-honored maxim that speaks to the power that compound interest can have on a long-term investment. Simply stated, divide 72 by an investment’s expected growth rate to help estimate when the initial investment could double in value. The rule of 72 does not, however, take portfolio fees and expenses or federal/state taxes into account. Applying this same principle to tax deferral helps illustrate how a tax-deferred investment may help benefit a portfolio over the long term.

 

Tax Deferral May Help Grow Portfolio Value Over the Long-Term

In the example below, a $100,000 investment grows at 6%. Thanks to the Rule of 72, we know that it could take 12 years for the money in a tax-deferred account to double, while a fully taxed (at 37%) account would take approximately 19 years to double.

Rule of 72, rule of 92, rule of 114


Sources: Legg Mason, Thomson. The chart shows hypothetical 6% growth over 30 years, with and without taxes. Taxes assumed at a 37% rate. This is a hypothetical example only and does not represent any specific investment product. Actual investments may include fees, charges and other expenses that would affect an investment’s return. It assumes no distributions are made during these periods. However, lower maximum tax rates on capital gains and dividends would make the investment return for the taxable investment more favorable. Changes in tax rates and tax treatment of investment earnings may impact the comparative results. Actual returns will vary.

Withdrawals of earnings from a tax-deferred account may be subject to ordinary income tax, and early withdrawals can be subject to an additional 10% federal tax and/or surrender charges. If an investor were to withdraw their entire account balance at the point in time at which the portfolio value had doubled, the redemption amount would be significantly lower. Taxes are assessed annually on taxable accounts. Investors should consider their own personal goals, time horizon and tax bracket when making investment decisions.
 

And After 30 years…

A tax-deferred account would be worth $574,349 (or $398,840 after taxes), compared with $304,376 for a taxable account. Investors in lower tax brackets (those with income below $612,350 or $510,300)1 would be unlikely to see as dramatic a difference between tax-deferred and taxable accounts.


Source: Legg Mason. For illustrative purposes only. The table serves as a demonstration of how the Rules of 72 works from a mathematical standpoint. Results are rounded. It is not intended to represent an investment. The table uses constant rates of return, unlike actual investments which will fluctuate in value, and is not guaranteed. It does not include fees, taxes or portfolio expenses, which would lower performance. It assumes no distributions are made during these periods. However, lower maximum tax rates on capital gains and dividends would make the investment return for the taxable investment more favorable. Changes in tax rates and tax treatment of investment earnings may impact the comparative results. Actual returns will vary. Withdrawals of earnings from a tax-deferred account may be subject to ordinary income tax, and early withdrawals can be subject to an additional 10% federal tax and/or surrender charges. If an investor were to withdraw their entire account balance at the point in time at which the portfolio value had doubled, the redemption amount would be significantly lower. Taxes are assessed annually on taxable accounts. Investors should consider their own personal goals, time horizon an bracket when making investment decisions. Past performance does not guarantee future results.
 

Don’t Forget The Impact Of State Taxes

State-level taxes can also have a dramatic impact on a portfolio. Some states - such as Florida, Nevada and Texas don’t have state income taxes. Other states, including New York, New Jersey and California, have top marginal rates ranging from 8.8% – 13.3%2, making it a very important consideration. You should, of course, speak with your financial and/or tax professional for more information on how the nuances of taxation will impact your personal situation.
 


Your financial professional can help you develop a long-term investment plan with a balance of strategies that addresses your need for portfolio growth, income, capital preservation and risk management.

 

1 On January 1, 2019, the income threshold for the top tax bracket changed to $510,300 for single filers and $612,350 for married couples filing jointly. Source: IRS.

2 Source: https://www.thebalance.com/state-income-tax-rates-3193320

All investments involve risk, including possible loss of principal.

Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, a forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.

Legg Mason, Inc., its affiliates and its employees are not in the business of providing tax or legal advice to taxpayers. these materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties or complying with any applicable tax laws or regulations. Tax-related statements, if any, may have been written in connection with the “promotion or marketing” of the transaction(s) or matter(s) addressed by these materials, to the extent allowed by applicable law. Any such taxpayers should seek advice based on the takepayer's particilar circumsyances from an independent tax advisor.