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.
Unless you invest in a tax-sheltered account, you will
have to pay taxes on any investment growth at your regular
income tax rate. Interest rates paid on bank
accounts, bonds and dividends (shared profits) are all
generally taxable. If you are in a moderate tax
bracket, this could mean around 30–35 percent in both
state and federal taxes. So your 10 percent rate of
return could end up being closer to 6 percent after
taxes.
The answer can be found in tax-sheltered accounts.
A
tax-sheltered account lets interest grow within
your account without being taxed until it is
withdrawn. This puts the power of compounding back
into your hands, because your investment will continue to
grow faster without taxes cutting into your growing
interest. What kinds of tax-sheltered investments can you
use to protect your compounded interest?
• Tax-deferred retirement plans such as
IRAs
• Municipal bond funds with reinvested
dividends
• Tax-deferred annuities
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