I rant talk a lot about the importance of maxing out contributions to tax-advantaged accounts (IRAs, 401(k) plans, Roths, etc.). Since you can’t “catch-up” later, anytime you don’t contribute the maximum (or if you withdraw more than required) you are reducing the benefits of these accounts.
(It’s one of my four rules for guaranteed financial success.)
That probably sounds pretty anodyne, but I think this is really important and I don’t think people really grok it – particularly in an inflationary environment. The tax code imposes taxes on those phantom gains!
Let’s assume a tax rate of just 25% (it keeps the math pretty easy) and an investment with no real return (if there is a higher real return the tax-advantaged account is even better).
The United States actually already has a wealth tax of sorts created by the intersection of the tax code and inflation. At 25% tax rates and 2% inflation (the Fed’s target) we are all subject to a wealth tax of half a percent per year on many investments (the taxable ones). At an inflation rate of double that, it’s 1%. At a tax rate of 50% rather than 25% it would also double to 1%. This past year inflation was 6.5%, so for higher income people, who may have a marginal rate of around 50% in a high tax state, they have had a wealth tax of 3.25% on investments generating ordinary income that were not sheltered in retirement accounts! (Under the current tax code, if you hold investments until death you can avoid taxes on the unrealized gain portion though.)
So, in a taxable account, you lose your marginal tax bracket times the inflation rate since you bought the asset. You may have high returns so that you didn’t feel it, but the government still effectively confiscated a portion of your property if there is any inflation at all.
At zero inflation or zero tax rates you lose nothing, but as inflation and rates increase you lose more and more. But in a tax-advantaged account you lose nothing! (Assuming you don’t commingle pre-tax and after-tax funds.)
Let’s do four examples: Deductible IRA (same math as a 401(k), 403(b), etc.), Roth IRA, Taxable Account, and Non-Deductible IRA.
We’ll assume just a one-year holding period (the differences increase significantly over longer periods due to compounding), a 25% tax rate (low for ordinary income property, about right for capital gains for many people), and 10% inflation (high, but in 1980 it was 12.5%). This will show how terrible inflation is (because of the tax code). Our hypothetical investments will just keep up with inflation – so you “really” don’t make anything. Of course the math is the same if you made 10% when inflation was a low figure, but it seems particularly painful when you pay taxes when you really didn’t even get ahead!
- Deductible IRA:
- You make $1,000 (which would be $750 net spendable after income taxes).
- You contribute it to your IRA and pay no taxes on it (because it was deductible).
- The $1,000 grows 10% to become $1,100.
- You liquidate and pay 25% in taxes or $275 leaving you with $825.
- Recap: including all taxes, you could have $750 to spend immediately or $825 a year later. That’s 10% return.
- Roth IRA:
- You make $1,000 (which would be $750 net spendable after income taxes).
- You pay $250 (25%) in income taxes and put the remaining $750 in the Roth (no deduction).
- The $750 grows 10% to become $825.
- You liquidate and pay no taxes (because it’s a Roth).
- Recap: including all taxes, you could have $750 to spend immediately or $825 a year later. That’s 10% return.
- Taxable Account:
- You make $1,000 (which would be $750 net spendable after income taxes).
- You pay $250 (25%) in income taxes and put the remaining $750 in the Taxable Account (no deduction).
- The $750 grows 10% to become $825.
- You liquidate and pay $18.75 (25%) in taxes on the $75 gain.
- Recap: including all taxes, you could have $750 to spend immediately or $806.25 a year later. That’s 7.5% return.
- Non-Deductible IRA:
- You make $1,000 (which would be $750 net spendable after income taxes).
- You pay $250 (25%) in income taxes and put the remaining $750 in the IRA (no deduction).
- The $750 grows 10% to become $825.
- You liquidate and pay $18.75 (25%) in taxes on the $75 gain.
- Recap: including all taxes, you could have $750 to spend immediately or $806.25 a year later. That’s 7.5% return.
So if you use either fully deductible or fully tax-free accounts you don’t lose anything at all to taxes on growth (even phantom growth due to inflation), but if you use a taxable account or an account that is merely tax deferred, you lose your tax bracket times your growth rate each year.
(The above is an oversimplification that assumes full recognition of gains, etc. each year. Over multiple periods the non-deductible IRA will win vs. the taxable to the extent there are dividends, interest, and turnover, on the other hand, the taxable account will win vs. the non-deductible to the extent the returns are taxed as capital gains rather than ordinary income. But in all cases using a fully tax-deductible or tax-free account wins over taxable or merely tax-deferred. If your tax bracket increases though, the Roth is better, if it decreases the deductible IRA is better. Full exposition here.)