by **afan** » Wed Dec 26, 2012 8:06 pm

Since the exercise of paying the taxes out of a separate fund leads to increases in investment in the taxable account, it distorts any attempt to analyze the returns. The after tax return on the taxable account under this assumption- 4% pretax return, 33% tax rate- is 0.67 x 4=2.68%. That is the return, no matter how you pay the taxes.

Taxable:

invest 10,000 at 2.68% for 20 years. The final value, after tax would be $17,265.

Tax deferred: invest 10,000 at 4% for 20 years. At the end, cash out, pay tax and keep the rest.

value before tax is 21,911 including 11,911 of gain.

at 33% tax rate, the after tax value is 17,980. More than the taxable account.

at 39% tax rate, the after tax value is 17,265. Same as the taxable account.

If the tax rate for the gain in the deferred account were greater than 39%, while the rate on the taxable remained 33%, then the taxable account would be a better deal.

Now assume you defer for 40 years, instead of 20. The numbers change:

Taxable:

invest 10,000 at 2.68% for 40 years. The final value, after tax would be $28,803.

Tax deferred: invest 10,000 at 4% for 40 years. At the end, cash out, pay tax and keep the rest.

value before tax is 48,010 including 38,010 of gain.

at 33% tax rate, the after tax value is 35,466. More than the taxable account.

at 39% tax rate, the after tax value is 33,186. More than the taxable account.

Not only is deferral a better deal at 20 years at the same tax rate, and at a tax rate up to 6% higher for the deferred investment, but the superiority of the deferred approach increases as the time horizon increases.

If you start putting money into an after tax IRA at age 21, you have 50 years of deferral before you are required to start taking some out. But then you do not need to take it all out. So the deferral continues to work in your favor.

Finally, remember that in the recent past one has been able to make charitable donations with IRA funds without realizing the income, or paying tax on it. If one were to do this, then the effective tax rate on the IRA would become zero. You do not have this option with a taxable bond investment. Another advantage of deferring income.

"We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either."

--Larry Swedroe