A common misconception is that 401(k)s and IRAs save you from income tax. They don’t, but they do save you from capital gains tax. With compounding, the additional earnings from tax-advantaged accounts over taxable accounts can be large.
Tax-Advantaged Accounts Do Not Save You From Income Tax
Yes, money you contribute is removed from your paycheck before taxes are applied and therefore that money isn’t taxed before being invested. However, money you withdraw from your 401(k) is considered income and is taxed as income at that moment, which is why 401(k)s are called “tax-deferred” accounts. Whether you opt to route money from your paycheck to a 401(k) or route that money to your checking account, you will pay income taxes on that money eventually.
Moreover, whether you pay income tax at time of paycheck or at time of 401(k) withdrawal doesn’t change the net amount you earn (assuming the same tax rate and rate of return). If you contribute $1,000 to a 401(k), it doubles in value to $2,000 and you withdraw it at 22% tax, you’ve earned $1,560. If you take the $1,000 into a checking account after a 22% tax, take the remaining $780 and invest it in a taxable account that doubles in value, you’ve again earned $1,560.
So How Do Tax-Advantaged Accounts Save on Taxes?
The realized gains on taxable investments are subject to capital gains taxes whereas the realized gains on tax-advantaged investments are not. Realized gains are the profits you earn by selling investment shares that have increased in value since you bought them.
You save by not having to pay capital gains taxes of 15-20% on your investment gains, depending on your tax bracket.
This 15-20% savings can have a significant impact—much greater than 20%—on the net amount you earn thanks to the power of compound interest. Your investment accounts earn a percentage of your account balance. Those earnings also grow your account balance and so you earn even more money on those earnings. This has an exponential effect that over long periods of time can make you very wealthy.
While the same exponential effect happens with taxable accounts, any capital gains are taxed 15-20% every year, creating a “tax drag” on your otherwise faster exponential growth with tax-advantaged accounts such as 401(k)s and IRAs.
Below is a hypothetical example from Goldman Sachs comparing the balance of a $200,000 tax-advantaged account to a $200,000 taxable account over 25 years.1
Over 25 years, the tax-advantaged account has $349,000 or over 51% more in it than the taxable account! Even after only 5 years, the tax-advantaged account has $22,000 or over 8% more in it than the taxable account. The difference between the accounts is the 20% long-term capital gains tax dragging down the returns of the taxable account. This example’s assumptions exaggerate the balance differences when compared to the average investor, but the underlying impact of tax drag on a compounding balance remains the same nonetheless.
How Tax-Advantaged Accounts Could Limit Your Income Tax
Changes in your income tax bracket can limit your income tax.
If your income tax bracket is higher now than it will be in retirement, you can save by investing in a Traditional 401(k) or Traditional IRA since you’d rather avoid paying income tax now in favor of paying it in retirement when your income tax bracket is lower.
If your income tax bracket is lower now than it will be in retirement, you can save by investing in a Roth 401(k) or Roth IRA since you’d rather pay income tax later instead of paying it in retirement when your income tax bracket is higher.
From a tax perspective,
You should favor a Traditional 401(k) or Traditional IRA if:
- Like most people your expenses will be the same or lower in retirement, which is common for those who plan to retire early.
You should favor a Roth 401(k) or Roth IRA if:
- Contrary to the norm, your expenses will be much higher in retirement than now.
- You strongly believe income taxes will rise by your retirement date.
Another key reason to choose Roth accounts over Traditional accounts is for liquidity of money, which we’ll cover in another post.
When considering only taxes, the vast majority should favor Traditional tax-advantaged accounts.