The Goal is to Focus on Maximizing Overall Tax Savings
The major goal here is of course tax reduction and in the end this decision should come down to what approach will lead to the least amount of tax payable, especially since you can make similar investments in either type.
So, this isn’t a matter of whether you want to put all of your money in a growth portfolio, or desire some other mix of assets, as these plans are designed to pretty much allow investors to decide what they wish to put their money into. There are some restrictions, but they tend to apply to both classes of investment accounts.
It’s not that hard to decide what proportion of one’s portfolio they should have in Roth IRA type accounts, and this isn’t something we have to be very exact with anyway, although having a good understanding of how these accounts work will tend to lead to better decisions about allocation.
As it turns out, in order for a tax avoidance account to be able to keep up with the overall return of a tax deferral account, we need the expected return to be high enough. This only makes sense due to the entire benefit of a tax avoidance account being to avoid tax on income earned, so we have to earn enough to offset the additional benefits that tax deferral accounts offer, most notably, paying a lower tax rate on the principal in retirement.
Let’s take a simple example where one invests $100,000 in each type of plan, where the current marginal tax rate is 35% and it’s expected to be reduced to 25% in retirement. We’ll then compare a scenario where one achieves a 25% return on investment over a certain number of years, a 100% overall return, and a 150% overall return to see how they compare.
The retirement account defers $35,000 in tax initially, for a total amount of $135,000. With the tax avoidance account, the principal starts out at $100,000, so you can see that the retirement account does get a head start.
With the 25% return overall over time, the retirement account grows to $168,750, which is now subject to a 25% tax rate, so we end up with $135,000 net once the tax is paid. The tax avoidance account grows to $125,000 and there are no further tax implications aside from not having to pay any tax on the 25% return, so in this case, the retirement account produces the better tax benefit.
With the 100% return though, the retirement account grows to $270,000, and after we deduct the tax, we net $202,500. The tax avoidance account doubles the initial investment to $200,000, so in this case they come out pretty even.
The Tax Deferral Amount is the Real Key Here Though
When we use the 150% total return, the retirement account nets $253,125 after taxes, where the tax deferral account grows to $250,000, so once again the results are the same. So, based upon the return model, if one expects to get a lower return, it becomes more important to focus on the tax deferring, where if the return is expected to be 100% or more, it doesn’t really matter very much, over the long term anyway.
If the difference in marginal tax rates is greater than the 10% we’ve been using, which is a fairly typical scenario, then the retirement account option becomes even more preferable, due to our being able to leverage an even higher amount over time. So, for instance if this was 20%, this would add enough to the result where all these scenarios would have tax deferral coming out well on top.
Another factor that plays a role is the amount of time until retirement. The shorter the time period involved, the more beneficial the retirement option will be, even though that might seem to be counter-intuitive.
The reason why this is the case is that there are two main benefits to tax deferral, using the deferred tax to invest, and the tax savings from the tax deferral itself. If we only have one year to go to retirement, and the difference in our marginal tax rates pre and post retirement is 10%, we will realize this benefit over a single year.
What this does is add to our overall return in the account, where this 10% tax benefit becomes diluted the more years the money spends in the plan. There are people who actually even realize immediate benefits from this, where they contribute a sum of money to a retirement account and withdraw it right away, where you can contribute in one tax year and claim it in the next. Realizing a 10% gain for instance over a period of a few weeks is pretty impressive indeed.
Tax Avoidance Accounts Do Make Sense in Some Scenarios
In spite of retirement accounts being at the very least competitive with tax avoidance accounts in terms of overall net tax savings, and often preferable, this may have us wondering whether we should ever prefer the tax avoidance option.
If we have contributed the maximum to our retirement accounts, this leads to an easy decision, as we then just need to decide whether we want to pay tax on our investment gains or not. In this case, we should always prefer to avoid this tax of course.
Should we not expect to pay a lower tax rate when we cash in the investments in retirement, this is going to matter, and this is going to of course favor the tax avoidance type of account. If we take the 100% return over time example for instance, if the marginal tax rate stays at 35%, the initial $135,000 grows to $270,000, which is taxed at 35%, reduces to $175,000, versus the $200,000 that the tax avoidance account provides.
The tax deferral option does require a tax savings in the end to be the better option, and even though most people expect to see this, if the reduction is not expected or if it will be very small, this can make tax avoidance accounts the better choice.
People save for reasons other than retirement though, and this is where tax avoidance accounts can really shine. Depending on the jurisdiction, there may be conditions attached to withdrawing amounts from these accounts, such as with the Roth IRA, or there may not be, and one may be able to just take the money out any time they like, for whatever purpose.
In any case, these accounts are not aimed at retirement generally, and at the very least offer greater flexibility than retirement accounts as far as when one is required to take the money out of the account.
Retirement accounts, being geared toward our retirement years, base their contribution levels on earned income, meaning that after you retire, you generally won’t be allowed to contribute very much if anything to it. There also may be restrictions where you have to take a certain percentage of it out each year after you reach a certain age.
Tax avoidance accounts, since they aren’t really as dependent upon retirement, avoid these issues, and as one enters into retirement and beyond, they become a particularly good choice in one’s strategy to minimize taxation, and may become the sole choice at a certain age.
This allows people of even advanced age to continue to realize their tax benefits, especially if they are living off their investments to some extent and of course wish to keep more of this income and give the government less.
The Roth IRA does have age limitations, where you can’t contribute past age 70.5, but other types do not have this issue. Even the Roth IRA allows people to contribute past retirement, where it does not make sense to do so generally with a tax deferral account.
It is this increased flexibility that make tax avoidance accounts such a good option in many circumstances, especially if you are in retirement already. If you are saving for things other than retirement, this certainly be the case as well, and especially if you are seeking a higher rate of return.
The higher the return, the more taxes you save, and the higher your marginal tax rate is, the more tax you will save as well.
It should not be all that difficult of a decision at all as far as how to allocate your savings between these accounts, once you have a basic idea of how this all works, even though you do have to do a little math and make a few reasonable projections.
If you are saving for retirement, a retirement account that defers taxes on the principal to retirement is a great choice provided that you expect to pay a lower tax rate in retirement. Otherwise, tax avoidance accounts are the better choice.