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The Key to Dividends Is Tax-Deferred Compounding

Odds are that saving for retirement will be your biggest life expense. For most of us, that expense will be a number in the six or seven figures. There are a lot of moving parts required, in order to hit the goal of having enough income to last through the “golden years.” And while we can’t control some things like rates of returns or volatility, we can control at least one thing – taxes.

Sure, politicians, Republican or Democrat, will undoubtedly continue to raise them for years to come, but we as investors can have a few tricks up our sleeves to help minimize their effects on our nest eggs. One of the best involves “kicking the can” as far as we are able to. Tax-deferral is one way to grow a nest egg through dividends and other gains.

Shelter Those Assets

One of the biggest tax benefits available to almost every investor under the sun has to be the tax-deferral benefits of accounts such as the 401k, 403 b and IRA. By design, these accounts allow investors to sock away money, add plenty of compound interest and pay no taxes, until the money is withdrawn. 65% of Americans have access to a workplace retirement plan, like a 401k. Almost everyone has the ability to open up an IRA.

The key is that all of this compounding occurs away from the watchful eye and grabby fingers of Uncle Sam. The more money that stays in the account and doesn’t go to taxes each year, the greater the compounding effect. For those in higher tax brackets, it’s a godsend. In fact, it’s probably the most important aspect in all of personal finance when it comes to retirement.

The Power of Tax Deferral

For example, someone in the 25% tax bracket who earns $2,000 worth of interest in a taxable account would owe the government $500 in taxes. That means only $1,500 would be available to reinvest the following year. At first that may not seem like a big deal, but over time it can mean a ton of difference in account values.

Want a real long-term example on compounding and tax deferral? Take this example from BB&T bank. Stuffing $5,000 annually into an IRA and a taxable account earning 6% would be a difference of about $100,000 for someone in the 28% tax bracket. The IRA would have just over $395,000, while the taxable account would have just $295,000.

Now, I know what you are thinking. You’ll have to pay taxes on the IRA withdrawals. And that is true. However, even when accounting for the nearly $69,000 in taxes due on the withdrawal, the tax-deferred investor is still ahead – with an additional $31,000.

The tax-deferral effect is particularly of interest for dividend-growth investors. Buying stocks that continually raise their dividends, and then using those dividends to buy more shares of the stock, is one of the best ways to super-charge compounding. It’s basically doubling the compounding: once for the rising dividend, and then again for the additional shares you now own from the reinvestment. By sheltering the effect, investors are able to keep more of the “dividend growth” for themselves.

What About a Roth?

Roth’s can be good too, since they eliminate taxes all together. However, they aren’t a panacea either. For one thing, workers in higher tax brackets often see their taxes fall – by a lot – when they finally retire, which then eliminates many of the benefits of the Roth. Especially since higher income workers can benefit from the tax deferrals and tax breaks that come with investing in a 401k and traditional IRA.

There is also the pesky fact that Roth’s may not be around forever. The idea of killing the Roth or having it subject to taxes if it is above a certain value has already been floated around.

For many Americans, the appeal of the Roth might not actually be as great as we think.

Tax Deferral Is Simply the Way to Go

In the end, tax-deferred accounts offer plenty of benefits to investors, not including higher potential balances. For dividend-growth investors looking to exploit the “doubling effect” of the investing style, they offer a powerful way to get the most bang for your buck.

And given the many positives, workers should be looking to max out any tax-deferred accounts they have – whether it is a workplace plan like a 401k or an individual retirement account, such as a SEP IRA.

The goal is to get the most you can out of them. Now that you see how big the benefit can be, start saving.