Even after taxes, tax-deferred investing beats out annually taxed investing
By Shane Flait © 2008

The eventual taxation of tax-deferred investments leaves you with more than if that investment gave you earnings that are annually taxed. And the longer you go without withdrawing from the tax-deferred investment, the magic of compounding makes its advantage explode.

The benefit of tax-deferred investing over annually taxed investing is greatest when applied to investments that produce yearly earnings that would be annually taxed. Such investments would be bonds, income-based mutual funds, and stocks whose main returns are dividends since all these are taxed annually – and I’ll call them taxable funds.

Let’s assume you have $100,000 in a taxable fund. If it grows at 7% per year, you’ll have earnings of $7,000 at the end of the year. Unfortunately, being taxable, these earnings will be taxed at your ordinary income rate of – say - 25%.  As a result you only get to keep 75% of your $7,000 which is $5,250 to keep on growing. Your after tax growth rate is only 75% of 7% which is 5.25%. That’s the actual rate at which your investment will grow (and compound) every year.

A tax-deferred fund –on the other hand - grows at the hypothetical 7% rate since no annual tax is imposed on its earnings. It’ll compound at the full 7% rather than at the 5.25% rate of the taxable fund.

However, when you do withdraw your money from the tax-deferred fund, you’ll have to pay tax on all accumulated earnings at your ordinary income tax rate. You might think that this would wipe out all the benefits of the tax-deferred earnings. But it won’t as we’ll see below.

Let’s compare the net after tax money from a tax-deferred fund vs taxed fund over a 20 year period. This represents the investment period of many beginning retirement at age 65.

To see the advantage of a tax deferred fund over a taxable fund we’ll compare the after tax growth of $100,000 in each. In particular we’ll compare the money available after withdrawal from each fund at each 5 year interval. We’ll assume a 7% annual investment rate coupled with a 25% tax rate on all earnings and withdrawals. The results are shown in the table. 

Comparison of after tax value of tax-deferred to taxable fund at 5, 10, 15, and 20 years
1	Number of years held before withdrawal:	0	5	10	15	20
2	7% taxable growth fund (i.e. taxed yearly):	100,000	129,155	166,810	215,443	278,254
3	7% tax-deferred growth fund but then taxed at 25% rate at end of number of years:	100,000	130,191	172,537	231,927	315,226
4	Excess after tax earnings of tax-deferred fund over earnings of taxable fund:	0	1,037	5,727	16,485	36,973
5	% of $100,000 of Excess after tax earnings of tax-deferred fund over taxable fund:	0	1%	6%	16%	37%

The 2^nd row shows what the taxable fund would grow to after the yearly tax is applied at 5 year intervals. So it’s all available as after tax money. The 3^rd row shows the results for the tax-deferred fund after withdrawing all earnings and taxing them. This row shows what available as after tax money. It’s clearly more than the taxable fund. The 4^th row shows just how much more!  You can see the excess after tax earnings grows fast if given time. This is the magic of compound earnings.

The last (5^th) row shows just how much this excess after taxed earnings of the tax-deferred fund over and above the earnings of the taxable fund is as a percentage of the initial $100,000 investment.

One lesson to learn from this beyond the benefit of tax-deferred investing is knowing which funds to withdraw money from first:

If you have both tax-deferred funds and comparable taxable funds that both give yearly tax able earnings, withdraw from the taxable funds. Doing this keeps you’re tax-deferred funds compounding to earn you more and more.

 

Shane Flait is a writer and educator. See more at www.EasyRetirementKnowHow.com