The Effect of Taxes on 
Compounded Interest

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 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. So a 10% rate of return could end up being closer to 6% 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 A tax-sheltered account lets interest grow within your account without being taxed until it is withdrawn.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. Here are some tax-advantaged strategies to consider:

  • Tax-deferred retirement plans such as individual retirement accounts.
  • Municipal bond funds with reinvested dividends (only income dividends are free of federal tax, but may be subject to state and local taxes). Municipal bonds generally pay simple interest: the compounding effect occurs when the interest dividends are used to purchase additional bonds within the fund.
  • Tax-deferred annuities.

A tax-sheltered account puts the power of compounding back into your hands, because your investment will continue to grow faster without taxes cutting into your growing interest. You should also consider whether you tax-sheltered investment also shelters income from state and local taxes as well.