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Traditional IRA accounts and 401(k) plans each carry the same tax structure. Until their contribution limits are reached—in 2024, $7,000 for IRAs and $23,000 for 401(k)s, with higher amounts allowed for those aged 50 or over—each year’s savings are tax-deductible. In addition, earnings on those investments are protected until the moneys are withdrawn, during retirement.
An instant write-off when investing, with ongoing tax protection for up to several decades, makes for an enticing offer. At the last report, Americans held $21 trillion in tax-sheltered investment accounts—more than the worth of any stock market in the world, save for that of the United States.
As popular as such accounts are, questions remain. Who among us can specify the precise benefit of that structure? Does using an IRA/401(k) increase the final aftertax value of a portfolio by 10%, when compared to the total for an otherwise equivalent taxable account? By 20%? More? Less?
The Backdrop of IRAs and 401(k) Accounts
There are two key advantages to IRA/401(k) accounts. (As this article does not consider Roth IRAs, I will cease using the adjective “traditional.”)
1) Current tax deduction. If the contribution limits are observed, the investment amount is immune to all US taxes from that calendar year—federal, state, and local.
2) Ongoing tax deferral. Until money from the accounts is withdrawn, which need not occur until ages 70½ through 75 (the details vary according to the investor’s birth year), all taxes are suspended. This provision shelters not only the income and/or capital gains generated by the investor’s actions but also mutual fund and exchange-traded fund distributions.
The first item always delivers. Tax-deferred structures put all investment dollars to work. In an IRA/401(k), a $5,000 contribution means that $5,000 is allocated to the portfolio. Not so with taxable accounts. For example, if a single worker in a 22% federal tax bracket wishes to invest $5,000, he must set aside $1,100 for the government. Thus, his portfolio receives only $3,900.
In contrast, while the second feature of ongoing tax deferral can be important, its utility is situational, as an investor holding a portfolio that consists solely of non-dividend-paying stocks would receive no reward whatsoever from ongoing tax deferral. To be sure, owning an IRA/401(k) would still be the right decision, because of the initial tax deduction, but there would be no further tax benefit.
Today’s Study
This article could easily be a lengthy white paper, exploring the interplay between differing tax rates (including state and local levies), time horizons, and investment choices. Thousands of such combinations exist, never mind the additional complications introduced by varying investment features. Also, as the federal government regularly changes tax rates, a thoroughly accurate evaluation would include the ability to predict the regulatory future.
We will not descend those rabbit holes. Instead, this article will consider the case of but one investor. For this test subject, I selected the previously mentioned tax bracket of 22%, both during the investor’s working years and in retirement. That bracket covers a broad income spectrum, ranging from $44,276 for a single taxpayer to $190,970 for a married couple filing jointly. What’s more, the adjoining higher bracket, which roughly doubles those upper limits, is barely different, at 24%.
To keep things simple, I evaluated a one-time contribution of $5,000. The aftertax value of this purchase—$5,000 for the IRA/401(k) and $3,900 for the taxable account—was placed into one of three investments: 1) a zero-dividend stock portfolio, 2) a stock market index fund, and 3) a balanced fund that holds 60% of its assets in equities and 40% in bonds. I set the annualized total return for each portfolio at 8%. (That’s a decidedly optimistic estimate for a balanced fund, but the scientific method demands consistent inputs.)
I then let each portfolio ride for 40 years, from the investor’s beginning age of 25 to a hypothetical retirement date of 65, liquidated the portfolios, paid any relevant federal taxes, and calculated their aftertax worth. In practice, investors rarely dump their IRA/401(k) accounts as soon as they retire, but this simplification causes no harm. Whether the newly minted retiree sells now or later, the relative values of the comparison portfolios remain the same.
The computation debits the taxable account each year for the amounts that its owners owe to the IRS, due to the dividend/income distributions made by their funds. That, to be sure, is an unrealistic assumption. Investors don’t write checks from their stock or balanced funds to settle their investment tax bills. However, the money for those payments must come from somewhere. It seems only fair to dock that source for the future value of those assets.
The Results: IRA and 401(k) Tax Benefits
Enough ado! The following chart shows the final values of each portfolio after it has been liquidated and its federal taxes paid.
Working & Retirement Tax Rates of 22%
The IRA/401(k) totals do not change, regardless of the underlying portfolio. If the performances are identical, as assumed in this exercise, tax-deferred accounts are unaffected by the investment details. A $5,000 purchase compounded for 40 years grows to $108,623, which after forfeiting a 22% tax becomes $84,726. End of story.
For the zero-dividend portfolio in the taxable account, the math is equally straightforward. Its $3,900 initial investment appreciates to $84,726, which matches the final value for the IRA/401(k). The accounts are the same because each paid a 22% income tax, in one case upfront and in the other later. However, the taxable account must pay the IRS once more, for the $80,826 capital gain that it accumulated over those four decades.
The figures drop steadily with the other two portfolios, depending upon the amount of their annual distributions. Although my assumptions for the size of those payouts are stingy—I assume that the investor makes no trades and that the funds declare no capital gains—compounding ensures that those small cuts extract a large toll. “Over time, that shalt regret every investment penny that thou hast squandered.” So sayeth Jack Bogle’s First Commandment.
Conclusion
To address this article’s original question, for investments made over a full working career, from age 25 to 65, IRA/401(k) accounts improve the final aftertax value of the study’s assets by 17% for a no-dividend portfolio, 30% for a stock market index fund, and 44% for a low-turnover balanced fund. Those figures, of course, will vary according to personal circumstances, but I conducted enough offscreen spreadsheet tests, using different tax brackets, to conclude that they are broadly representative.
It’s important to note that these numbers reflect a 40-year holding period and that the advantage for IRA/401(k) accounts declines sharply over time. There’s not much benefit to sheltering short-term investments from taxes, because that same IRS bill will arrive sooner rather than later. That said, it’s also worth noting that the early contributions into IRA/401(k) accounts tend to become the largest portion of such accounts, thanks to the power of compounding.
In short, IRA/401(k) plans are a very good deal. And should the latter offer a company match, they become a truly great deal.