Understanding How Money Grows and How Its Taxed

Money management and investments are pivotal in ensuring a secure financial future. Money can primarily grow in three ways: fixed, variable, and indexed. Each growth mechanism has distinct characteristics and is suitable for differentinvestor profiles. Understanding the tax implications associated with these growth mechanisms—taxed annually, deferred, or with tax advantages—is crucial for maximizing your returns. Let's delve into these concepts to gain a clearer understanding.

How Money Grows

Fixed Growth

A steady and predictable return rate over time characterizes fixed growth investments. Examples include savings accounts, certificates of deposit (CDs), and fixed annuities. These investments are generally considered low risk because the financial institution guarantees the rate of return, making them an ideal choice for conservative investors or those nearing retirement who prioritize the preservation of capital over high returns. Uncle Sam loves it when we put money there, but because the gains are taxed annually, you never really get to compound all of your cash because it grows and then taxed again, essentially we're taxed twice on our money (post tax deposit, & annual gains), versus compounding on top of each other, which makes a significant difference long term.

Variable Growth

Variable growth investments, such as stocks, mutual funds, and variable annuities, offer returns that fluctuate based on market performance. These investments have the potential for higher returns compared to fixed growth investments but come with increased risk. The value of these investments can significantly rise or fall, making them more suitable for risk-tolerant investors and those with a longer time horizon who can withstand market volatility. Unlike fixed funds, which are annually taxed on gains, these funds have tax-deferred compounding growth.??

Indexed Growth

Indexed investments, like indexed annuities, indexed life, or index funds, grow based on the performance of a specific market index, such as the S&P 500. These investments provide a middle ground between fixed and variable growth, offering the potential for higher returns than fixed growth investments while mitigating some of the risks associated with direct market investments. Some indexed investments have a cap on maximum returns. Still, they may also offer a guaranteed minimum return, making them attractive to moderate-risk investors. With specific indexed strategies, rather than putting your money directly in the market where you're subject to loss, you can place your money through an insurance company that backs and guarantees your funds and allows you to do market mirroring. The difference with market mirroring is that your money is not directly in the market. The insurance company uses the market to calculate your returns each year. So, if you're mirroring the S&P 500 and the S&P 500 goes up 10% or 15%, your account would be credited 10% or 15% or whatever the market did. Still, the following year, if the market dropped 30, 40, or 50% as it did in 2008, since your money is not actually in the market, you don't make anything in a negative year, but you don't lose anything either. They accomplish this by buying options. Options allow the insurance company to exercise options on a good year, and let options expire on a bad year (which is why you don’t lose during bad years).

How Money Is Taxed?

Taxed Annually

Investments that are taxed annually require investors to pay taxes on their earnings within the fiscal year they were earned. Interest from savings accounts and stock dividends are typical examples where taxes apply annually. This method directly impacts an investor's annual tax liability and is an essential consideration for short-term investments.

Tax-Deferred

Tax-deferred investments allow earnings to grow without being taxed until the funds are withdrawn, usually during retirement. Examples include traditional IRAs and 401(k)s. This is advantageous as it allows the investment to grow at a faster rate due to the compounding effect of the untaxed earnings. However, you are restricted from accessing these funds without penalty until age 59 ?. Also, you are subject to the tax, at whatever percentage it is, at the time you take distributions. Based on my previous article, we know that could be much higher, but ultimately, we do not know what the future will look like.?

Tax-Advantaged

Tax-advantaged investments offer benefits such as tax exemptions or credits to reduce the tax burden. Examples include Roth IRAs and cash-vesting life insurance policies, where contributions are made with after-tax dollars, allowing growth and withdrawals to be tax-free under certain conditions. In the case of cash vesting life insurance, there is no restriction on age to when you have access to these funds. They are liquid when needed, as long as the cash value is there.?

Conclusion

Choosing the right investment strategy involves understanding how money can grow and the associated tax implications. Whether you prefer the stability of fixed growth, the potential of variable growth, or the balance offered by indexed investments, it's essential to consider your risk tolerance, financial goals, and time horizon. Similarly, knowing how your investments are taxed can help you make informed decisions that optimize your returns and minimize your tax

liabilities. By carefully selecting your investments and tax strategies, you can work towards building a robust financial portfolio that supports your long-term objectives. If you want to know more about specific investments, learn their tax code and read about what they can do. HINT: the tax code for your 401(k) is….401(k). haha

***Educational Purposes Only. Written at high-level for easier context

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