Compounded Interest and Taxes

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Compounded Interest and Taxes

It will not do you a whole lot of good to compound the interest on your investments only to watch it get taken by the IRS. Fortunately, there are a few ways to compound your interest and avoid paying more tax than necessary.

Things To Know

  • Compounded interest in a tax-sheltered account can have added effects.
  • Certain retirement plans and annuities offer tax deferral.

Compound interest is normally taxable

Unless you invest in a tax-sheltered account, you will have to pay taxes on any investment interest at your regular income tax rate. Interest rates paid on savings/checking accounts and bonds, as well as dividends (shared profits), are all generally taxable. This could mean around 30–35% in both state and federal taxes for those in the United States. So a 10% rate of return could end up being closer to 6% after taxes.

Tax-sheltered accounts protect your earnings until withdrawn

The answer can be found in tax-sheltered accounts. A tax-sheltered account lets interest accumulate within your account without being taxed until it is withdrawn. This puts the power of compounding back into your hands, because your investment has the potential to grow faster without taxes cutting into your growing interest. Here are some tax-advantaged strategies to consider:

  • Tax-deferred retirement plans such as individual retirement accounts
  • Tax-deferred annuities

A tax-sheltered account puts the concept of compounding back into your hands, because your investment has the potential to grow faster without taxes cutting into your growing interest.