This tool compares tax deferral to tax favored investments. When everything else (tax brackets, rates of return, etc.) is the same, it shows the two alternatives are equal. |
Would you be surprised to find out that tax-deferred contributions to accounts that are taxable when withdrawn are the same as after-tax contributions that are withdrawn tax-free - assuming the same tax brackets and interest rates? Let me show you. Let's assume the following for both scenarios: A person has $5,000 to contribute each year for 30 years. They remain in a 30% tax bracket and earn a fixed 5% return each year. At the end of this 30-year period: •If the contributions were made to a traditional qualified plan (which accepts tax-deferred contributions and generates taxable withdrawals) they would have made pre-tax contributions of $5000 each year and the balance would have grown to $348,804. If the entire balance were then withdrawn, they would owe $104,641 in taxes and receive a net sum of $244,163. •If the contributions were made to a roth qualified plan (which accepts after-tax contributions and generates tax-free withdrawals) they would have made after-tax contributions of $3,500 each year and the balance would have grown to $244,163. If the entire balance were then withdrawn, no additional taxes would be due and they would receive the entire balance of $244,163. |
This screen emphasizes that accounts with tax deferred contributions, tax deferred growth and taxable withdrawals (such as a Traditional IRA) will yield the same results as accounts with after-tax contributions, tax free growth and tax free withdrawals (such as a Roth IRA) when all other variables are the same. Consider a simplified example; a client has: $10,000 pre-tax to invest; earns 10% per year; is in the 40% tax bracket; and has an investment period of one year (this is to keep the math easy to follow).
With a tax deferred/taxable investment: The client invests the entire $10,000. The client earns $1,000 in interest. The client withdraws the entire $11,000. The client pays 40% of the $11,000 or $4400 in tax. So the client has $6600 after tax.
With an after-tax/tax-free investment: The client pays $4,000 of the $10,000 contribution in tax. The client invests the remaining $6,000. The client earns $600 in interest tax-free. The client withdraws the entire $6600. The client owes zero in tax. So the client has $6600 after tax.
Notice both investments provide the same dollar results. The math works the same for longer (than one year) time periods. |