The Little Book of Main Street Money: 21 Simple Truths that Help Real People Make Real Money

Chapter 18. A Tax Deferred Is Extra Money Made

Why We Should Keep Uncle Sam Waiting

Occasionally, procrastination pays.

Much of the time, we're in a financial rush. The quicker we pay off our debts, the less interest we'll incur. The younger we start saving, the more we can potentially gain from investment compounding. The earlier we buy our first home, the sooner we can start building up home equity.

But when it comes to paying taxes on our investment gains, we should take it slow. If we can postpone paying Uncle Sam his share, we can use that money to notch additional investment gains—and that can give a big boost to our retirement nest egg.

Delaying the Day

Consider a simple example. Let's say you are age 40, you're in the 25 percent federal income tax bracket, and you invest $1,000 that goes on to earn 8 percent a year. If you pay taxes on your entire gain every year, you would have $4,292 at age 65. But if you postpone taxes until age 65 and then pay the bill on your 25 years of tax-deferred growth, you would amass $5,386. As you would expect, the longer you can delay the day of tax reckoning, the larger the advantage. Take the same scenario, but this time assume you invest for 40 years. If you pay taxes every year, you would have $10,286 after four decades, versus $16,543 if you put off the tax bill until the end.

How can you postpone paying taxes? There are two ways. First, you could fund tax-deferred retirement accounts, such as 401(k) plans, individual retirement accounts, and ...