How much more do you keep from investments in your retirement accounts?
Posted on February 23, 2024
I calculate that you gain at least 20% on the money you invest in retirement accounts relative to the same investment in a taxable investment account. I used a 25-year holding-period for your investment: if you are in the Save and Invest phase of life, that’s how long I assume you will hold your contribution this month to your retirement plan before you sell it for your spending. When I look back in time, that seems about right: Patti and I held the securities we sell for our spending for at least 25 years. Two components contribute to the +20% more: tax-free growth and avoiding tax on inflation. And you need time: those two provide a small benefit in ten years. It takes 25 years to reach that 20% benefit.
== Traditional = Roth ==
We want to compare the results from an investment in a taxable account to an investment in an IRA. To best understand, we need to start with the fact that a traditional (pre-tax) IRA gives the same after-tax return as a Roth (after tax) IRA; this assumes the marginal tax bracket at the time of contribution is the same as at time of sale of securities and withdrawal from the retirement account. In this example, I assume the marginal tax bracket is 22% at the time of contribution and at the time of withdrawal.
== Example: 14% more from tax-free growth ==
Once we understand that traditional = Roth, it’s a lot easier to understand when we compare an investment in a taxable account with the same investment in a Roth account. You already paid tax on the gross amount to invest in your taxable investment account or to invest within a Roth IRA.
• If you keep $1,000 in your taxable investment account, you will pay 15% capital gains tax on annual dividends and on the final gain at the time of final sale. (You may pay tax on capital gains distributions for some mutual funds, but let’s ignore that.)
• If you keep $1,000 in your Roth, you never pay these taxes: it’s obvious you will ALWAYS have more from Roth than from your taxable accounts. (The obvious caveat is that you do not violate the early withdrawal penalties from your retirement accounts.) You are not paying 15% tax on the growth over time. You are keeping 17.6% more of the growth for any holding-period.
The impact on the total that you keep depends on the amount growth vs. the initial investment. For the first few years, the total growth is small relative to the initial investment and the benefit of a retirement account compared to a taxable account is small. In the simple example below for 25 years, the growth portion is 5X that of the initial investment.
The simple example assumes all the gains are from price, not the combination of dividends reinvested and price. You only pay the capital gain tax at the end of 25 years. You have ~14% more from your Roth than you would from your taxable account.
== Perhaps 10 percentage points more ==
Three other factors make the benefit of a retirement account greater than 14% – perhaps 10 percentage points more, but I’ll just safely settle that an IRA results in 20% more than a taxable account.
• +3 percentage points: The benefit is really ~three percentage points greater when one calculates the impact of paying taxes on dividends on a taxable investment. A detailed calculation (It’s a big spreadsheet.) shows that you lose an increment of growth when you pay taxes earlier than in the simple example. This is a small effect for 10 years, but for 25 years the effect cumulates to 6% lower total growth and 3% lower net return.
• +2 percentage points: The benefit is two percentage points more because an IRA escapes the capital gains tax on inflation. The cost basis of an investment is not adjusted for inflation. The gain you calculate includes a portion that is just inflation. I calculate that the real capital gains tax rate is about 17% for the example of 25 years and 6X real growth.
• +4 percentage points: The benefit could be four percentage greater when one includes state taxes on capital gains. State taxes on gains vary. Nine states do not tax dividends or capital gains. Other states tax gains at 2.5% to over 10%. My state, PA, is on the low end and taxes dividends and capital gains at 3.1% and does not tax withdrawals from traditional or Roth IRAs. That would make the total capital gains tax in the simple case 18.1%. That raises the 14% benefit of an IRA to nearly 18%.
Conclusions: You benefit by about 20% greater after-tax return when you invest in a retirement account – either a traditional IRA or a Roth IRA – as compared to an investment in a taxable account. Obviously, this is for money you are investing for retirement, and I think 25 years is a proper holding-period for comparison.
Traditional (“Pre-tax”) IRA and Roth (“After-tax”) IRAs give you the same, basic after-tax return over time. You are gaining about 14% more in after-tax return primarily from tax-free growth of gains. You get a boost to 20% or more from escaping the tax on inflation inherent in the way gains taxes are calculated and from escaping state taxes on gains (This is varies according to your state).