Jeff Percival: ‘I saw your Parade piece last week, where you pointed out that someone in a tax-deferred plan is taxed on withdrawal as income, but someone not in a plan pays a lower (we hope) capital gains rate. This sounds great, but in thinking about it, I’m not so sure. I always thought that the key idea behind tax-deferred plans is that you hope to be taxed when you are retired, at a lower income bracket. Without this condition, I always thought it was a wash: after all, whether you tax your initial investment then double it, or instead double it first and then tax it, you end up with exactly the same amount of money. You only win if the tax rate at the end is lower than at the beginning.’
☞ Are you sure? For the sake of argument/simple math, say you’re in the 50% bracket now and will be at withdrawal. One way, you put in $1,000 now (pre-tax) and earn 10% a year (pre-tax) for 40 years. That $1,000 grows to $45,260 – and then half is taxed away, leaving you $22,630. The other way, outside a retirement plan, you put in $500 (what’s left of the same $1,000 of income after tax) and it grows for 40 years at 5% (not 10% because of tax) to $3,520. So it’s not a wash at all. In this example, you wind up, after tax, with more than six times as much. Why? Because for all those years you had the ‘government’s’ share of your money working for you as well as your own.
Using more realistic tax brackets and noting the likelihood of long-term gains treatment on appreciation outside the retirement plan, the gap narrows. But for most people, there’s definitely an advantage in tax-deferred growth, especially over long periods of time.
Did you read Paul Krugman’s column in the New York Times Friday? Click here. That California energy crisis may not have been so innocent, after all.