If you will, try to think of your ETF and other investment retirement plans — your 401(k), your IRA — as separate vessels of money. How much your nest egg grows depends not just on how much you put into it and which investments you choose, but also which vessels you have. Three basic kinds of vessels exist.
First are your basic vanilla retirement plans, such as the company 401(k), the traditional IRA, or, for the self-employed, the SEP-IRA or Individual 401(k). These are all tax-deferred vessels: You don’t pay taxes on the money in the year you earn it; rather, you pay taxes at whatever point you withdraw money from your account, typically only after you retire.
Next are the Roth IRA and the 529 college plans. Those are tax-free vessels: As long as you play by certain rules (discuss them with your accountant), anything you plunk into these two vessels (money on which you’ve generally already paid taxes) can double, triple, or (oh please!) quadruple, and you’ll never owe the IRS a cent.
Third is your non-retirement brokerage or savings bank account. Except for certain select investments, such as municipal bonds (“munis”), all earnings on your holdings in these vessels are taxable.
How much can your choice of vessels affect the ultimate condition of your nest egg? Lots. Even in a portfolio of all ETFs.
True, ETFs are marvelously tax-efficient instruments. Often, in the case of stock ETFs, they eliminate the need to pay any capital gains tax (as you would with most mutual funds) for as long as you hold the ETF.
Still, there may be taxes to pay at the end of the game when you finally cash out. And in the case of certain ETFs (such as any of the bond ETFs) that pay either interest or high dividends, you will certainly pay taxes along the way.
Suppose you’re an average middle-class guy or gal with a marginal income tax rate of 30 percent (federal + state + local). Next, suppose that you have $50,000 on which you’ve already paid taxes, and you’re ready to squirrel it away for the future.
You invest this money in the iShares GS $ InvesTop Corporate Bond Fund (LQD), which yields (hypothetically) 6 percent over the life of the investment, and you keep it for the next 15 years. Now, if that ETF were held in your regular brokerage account, and you had to pay taxes on the interest every year, at the end of 15 years you’d have a pot worth $92,680.
But if you held that very same $50,000 bond ETF in your Roth IRA and let it compound tax free, after 15 years you’d have $119,828 — an extra $27,148. And you would pay no income tax on this cash hoard when you eventually draw from it.
Unfortunately, the amount of money that you can put into retirement accounts is limited, although the law has allowed the sum to grow in recent years. For example, currently, the maximum annual contribution to the most commonly used retirement accounts, the IRA and the Roth IRA, is $5,000 if you’re younger than 50 and $6,000 if you’re 50 or older. (The amount is subject to change each year.)
Other retirement plans, such as the 401(k) or SIMPLE plan, have higher limits, but there is always a cap. (Ask your accountant about these plan limits; the formulas can get terribly complicated.)