Holding Time Makes Tax-advantaged Retirement Accounts Much Better Than Regular Taxable Accounts

by Shane Flait, ©2008

Because of the income tax rates imposed on withdrawals from government-regulated retirement savings plans – like IRAs - you may think that they’re not all that much better than using regular taxable accounts. Below I’ll show how your IRA-type account can eventually put a lot more in your pocket.

Relevant government-regulated retirement accounts, here, are any that allow tax-deductible contributions along with tax-deferred earnings, and withdrawals taxed at income rates. The IRA and 401(k) are examples.

I’ll compare the eventual after-tax earnings you’ll get from such plans – for different holding periods – with what you’d get from a regular taxable account that you contribute to with after-tax money and then has all its earnings taxed annually.

I’ll assume an investment for each account type that produces a 7% annual return which would be normally subject to income taxation. Such investment’s earning would come from interest or dividends. These are ideal investments for IRA-type accounts – i.e. trustworthy investments that produce reliable returns year after year - great for taking advantage of the tax-deferred nature of IRAs.

Though yearly contributions are limited for IRAs or 401(k)s, for simplicity I’ll assume you’ve accumulated some $100,000 in it. Also for convenience, I’ll assume everything is taxable at a 25% tax rate.

The key advantages that government-regulated retirement accounts give are:

• Tax-deferred earnings of your contributions, and
• Tax-deductible contributions

The advantage of the tax-deferred earnings is that your compounding rate for your tax-deferred investment will be larger than that for your taxable investment. That’s because for equal investment return, your taxable investment loses 25% of that return each year to taxation leaving only 75% of the return to compound. Remember, the magic of accumulated growth is in the compounding rate!

The advantage of the tax-deductible contributions is that you are able to get more into your IRA account than into you taxable account. That’s because you don’t lose a portion of your working income to current income tax when you contribute to an IRA. I.e. where you can contribute a full $1000 of your working income to an IRA, you’d only have 75% of that (i.e. $750) left after taxes to contribute to your taxable account. And of course, the more in your account to compound means the faster your earnings will grow.

Now, let’s compare the extra amount of earnings you’d get with a tax-deferred account compared with at taxable account after holding for 10 years and then 20 years. After holding for those periods, we’ll assume you paid all the taxes (at 25% rate) – so we’re comparing after tax-earnings you can pocket.

Tax-deferred advantage only:

To emphasis just the tax-deferred advantage of an IRA, we’ll assume you had the same initial investment of $100,000 in both types of account and that each investment produced a 7% annual return. Remember that the taxable account loses 25% of this return each year, so the compounding rate of the taxable account is only 5.25% (i.e. 75% of 7%) as compared to the full 7% for the IRA.

After 10 years, you’d pocket $72,537 of after tax earnings from your IRA versus $66,810 from your taxable account. That’s $5,727 more – or 6% more from your original $100,000 investment.

Waiting to 20 years, you’d pocket $215,226 of after tax earnings from your IRA versus $178,254 from your taxable account. And that’s $36,973 more – or a whopping 37% more from your original $100,000 investment – due to the benefit of tax-deferred compounding of returns.

That shows the benefit of the higher compounding rate that tax-deferred earnings give. It requires long holding times to build up – but it more than offsets the eventual income tax rates that the earnings are subject to.

And more including higher principal from the Tax-Deductible advantage:

We should really compare what we can pocket from an initial $100,000 contribution in the IRA to only a $75,000 contribution to the taxable account. That’s because both those contributions come from the same $100,000 of working income.

So for the same investment returns, we can see that

After 10 years, you’d pocket that same $72,537 of after-tax earnings from your IRA versus – now - only $50,106 from your smaller taxable account. That’s $22,430 more – or 30% more compared your $75,000 initial taxable account principal.

Waiting to 20 years, you’d still pocket $215,226 of after tax earnings from your IRA versus – now – only $133,706 from your smaller taxable account. And that’s $81,521 more money – a whopping 109% more compared to your $75,000 initial taxable account principal.

So, now you see the second advantage of your government retirement plan. And if your company will match contributions into your 401(k) plan, then that increased principal not only will give more earnings – but is a bonus itself that you couldn’t get with a taxable plan.

 Shane Flait is a writer and educator. Get more info at www.EasyRetirementKnowHow.com