Individuals with a desire to build financial wealth often favor retirement plans over taxable investment accounts. Each approach has different tax advantages that can have a major impact on the wealth that's created. We'd like to look at both pathways to see which one leads to greater after-tax wealth.
To briefly summarize, most retirement plans provide an immediate, upfront tax benefit as contributions are made. As the plan accumulates income and capital appreciation, all taxes are deferred until retirement, when assets are distributed over a period of years. All plan distributions are taxed as ordinary income.
In contrast to retirement plans, taxable accounts provide no upfront tax benefit. However, these accounts benefit from lower capital gains taxes. Taxes must be paid as income is received. They cannot be deferred as with a retirement plan.
Given the pros and cons of each savings vehicle, which one is likely to deliver better long-term results after all taxes are paid?
To find out, we used a hypothetical self-employed individual with $50,000 of pretax income to invest. Her choices were to invest the entire sum in her profit sharing/401(k) plan and avoid current taxation, or pay taxes and invest the remainder in a taxable account. We assumed her ordinary and capital gains tax rates were 40% and 25%, respectively. We also assumed an investment return of 6%.
With this information at hand, we compared her wealth accumulation at various points over a 20 year period. To make this a fair comparison, figures are shown net of all taxes.
Total After-Tax Wealth: Retirement and Taxable Accounts Compared
Here's what we learned.
After only five years, our hypothetical retirement plan is valued at $40,147 while the taxable account is worth $37,534 (you can see this by hovering over the bars). The advantage in terms of after-tax wealth favors the retirement plan by $2,613. By the ten year mark, the difference in wealth reaches $6,343. By 20 years, that difference grows to $19,142 on the original $50,000 pretax investment!
What can we conclude from these observations?
- In many cases, retirement plans can build significantly more wealth than taxable accounts can accomplish.
- The longer your time horizon, the greater the advantage offered by a retirement plan, though individuals with shorter time horizons still benefit.
- The more growth-oriented the investment strategy, the greater the advantage for retirement plans.
- The advantage favoring retirement plans is scalable by account size. For example, a $500,000 retirement account receives ten times the benefit as a $50,000 account.
- The strategy still works even if tax rates do not go down in retirement. In fact, our example used the same tax rates in retirement years as in contribution years.
Finally, we would be pleased to run some scenarios for you. Feel free reach out to us on our Contact Us page for a free consultation.
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Note:
We've assumed that all earnings are reinvested and all taxes are paid from their respective investment strategies. The 6% annual return breaks down to 2% of qualified dividends and 4% of capital appreciation. For the taxable account, taxes on qualified dividends are paid annually while taxes on capital appreciation are paid at the end. For the retirement account, all taxes are paid at the end.