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Taxed vs. Tax-Deferred

BY USING RETIREMENT accounts, or by pursuing tax-efficient strategies in a taxable account, you can get tax-deferred growth. How valuable is this growth? Imagine a husband and wife. Both invest $1,000 for 40 years and earn 6% a year before taxes.

The husband pays 22% in taxes every year on his entire 6% investment gain, so his $1,000 grows annually at an after-tax 4.68%. If you earn 4.68% a year for 40 years, your cumulative gain would be 523.1%. (On your financial calculator, this would show up as 6.231 before you subtract 1 and multiply by 100.) That means the husband’s $1,000 grows to $6,231.

Meanwhile, the wife puts her $1,000 into a nondeductible retirement account, where her money grows tax-deferred at 6% annually. After 40 years, she cashes out the account and pays 22% in taxes on her four decades of investment gains.

Before taxes, her $1,000 would grow to $10,286. What’s her after-tax gain? Remember, her contribution to the retirement account was nondeductible, meaning she didn’t get an initial tax deduction for her $1,000 contribution and hence she doesn’t have to pay tax on that $1,000 when she withdraws it. Instead, only the $9,286 in gains is taxable. Knock off 22% from that sum for taxes, add back the $1,000 nondeductible contribution and the wife would be left with $8,243, compared with $6,231 for her husband.

Next: Taxables vs. Munis

Previous: Rebalancing

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