Qualified Plans vs. Taxable Investments

Qualified plans out perform taxable investments because of the ability to defer the taxes on growth.

Be sure and illustrate the opportunity cost of the taxes in a taxable investment.

Qualified plans offer advantages such as deferral or postponement of taxes and possibly a company match. Let's take a look at how qualified plans compare to taxable investments.

To begin, let's assume one is just beginning to save and has nothing saved thus far. We'll also assume they have $5,000 of pre-tax income to contribute to either a traditional qualified plan or an ordinary taxable investment account each year. In either scenario they will remain in a 30% tax bracket and have a fixed 5% return over a 30 year period. However, if they invest in a qualified plan, their employer will match their contribution by an additional 50% - thus providing a company match of $2,500 each year.

At the end of the 30-year period the qualified plan account balance would be $523,206 with $156,962 of taxes due on withdrawal, leaving a net after-tax withdraw of $366,244.

Had the person instead chosen to fund a taxable investment account, their account balance after 30 years would be $187,003. While no additional tax would be due on withdrawal, they would have paid $161,801 in taxes on contributions and growth along the way.

In this scenario, the qualified plan account is the better choice by $179,241.

The math for this proof is solved with four worksheets: First, Second, Third and All Periods.

The math for this proof is calculated using two worksheets.

The two worksheets present the growth of the before-tax contribution qualified plan and the growth of an after-tax contribution taxable (or tax free) growth investment.  The qualified plan worksheet shows no tax during growth and a tax at withdrawal (the end of the investments life) based on the withdrawal tax bracket. The worksheet for a after-tax investment shows annual taxes on growth based on the current tax rate during the growth years.

As a summary the final results for both account types are compared side-by-side.

Initial Balance Clarification: In order to maintain a fair comparison, the initial balance used by the after-tax investment reflects the lack of matching funds during its accumulation period. That is, it assumes you have given up the company match in past years in order to fund the taxable investment.  For example, if the qualified plan initial account balance is $100,000 and the company match is $1 for $1, the taxable investment initial balance (in the first row) will be $50,000.  You have given up $50,000 in “match funds”.  In addition, taxes will be applied to the adjusted initial account balance of the taxable account to provide an appropriate comparative starting point.