Quantifying the Tax Benefit of Retirement Accounts for Better Client Decisions (Part 2)

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In my previous article, I showed how the value of tax-advantaged accounts depends on the tax-free investment income earned in those accounts. This article digs deeper into this dynamic to further demonstrate why the conventional wisdom of “stocks in taxable, bonds in tax advantaged” is not reliable. Compounding of tax-free investment income, protecting against tax policy changes, and avoiding taxes on inflation are all potential reasons for holding stocks in tax-advantaged accounts.

To reiterate from my prior article, the value of the tax benefit is the difference between the tax-advantaged accumulation and a (counterfactual) accumulation in a taxable account

where r is the periodic return, n the number of periods, and tc, td, and ti are the tax rates on contributions, distributions, and investment income, respectively.

While the tax rates on contributions and distributions are as of a point in time, the effective tax on investment income is spread over the investment period. It may be levied yearly on income distributions, at the time of sale as a capital gains tax, or as a combination of the two.

Estimating ti, which we can also think of as the annualized tax drag, involves lots of assumptions. In addition to future tax rates, the magnitude of the return, timing of the tax (annual or at sale), and length of the investment period are critical.

Figure 1 illustrates these factors. I am assuming pretax funds of $10,000. For the remainder of the discussion, the ordinary tax rates, tc, and td, are set at 20%, making us indifferent to a traditional vs Roth contribution. The tax benefit thus varies only with ti. I assume an 8% total return and a 2% dividend yield. I assume that in a taxable account both dividends and capital gains would be taxed at 15%. However, because capital gains are only taxed at the end of the period, ti declines over time. After 30 years it has dropped from the initial 15% to 8.7%.