The Power Of Tax-Deferred Growth by Tara Thompson Popernik, AllianceBernstein

With year-end approaching, many people are beginning to think about their plans for the New Year: vacations, resolutions, and how much to contribute to their retirement accounts over the next 12 months.

Employers that offer retirement savings plans, such as a 401(k) or a 403(b), typically ask employees to update their benefit elections each year. Since many young workers have most of their wealth invested in their employer’s savings plan, these elections are important to consider closely.

Investments in these plans grow tax-deferred, although eventually you pay tax on the distributions. At the top marginal rate, each $1,000 saved pretax to a retirement account would be worth about $600 saved after taxes. Over time, that difference can be huge. (The long-term benefits are also large for people in lower tax brackets.)

Tax-deferred investing is a very powerful benefit, because investors garner investment growth on dollars that would have been paid in taxes if they had not invested in the plan.

The left side of the Display below compares the impact of investing pretax dollars and saving in a taxable portfolio for a 30-year-old employee in the top bracket with the choice of saving $10,000 a year pretax for 30 years in an employer 401(k) plan, or investing about $6,000 a year after taxes. Either way, 60% of the portfolio is invested in globally diversified equities and 40% in fixed income. The tax-deferred portfolio invests in taxable bonds; the taxable portfolio invests in municipals.

Tax-Deferred Growth

We estimate that when the employee retires at age 60, the $300,000 total contributed to the qualified plan would grow to nearly $1 million in typical markets; and the $180,000 in the taxable account, to $420,000.

But that’s not the end of the comparison. Because she didn’t pay income tax on the salary deferred into the plan, she would owe income tax at ordinary rates on every dollar withdrawn in retirement. By comparison, for the taxable account, the only potential unpaid income tax due is related to any unrealized capital gains.

But even after comparing the accounts on an after-tax basis, she would be far better off investing in the qualified plan, as the right side of the display shows. We estimate that by the time she retires at age 60, the median after-tax advantage of the qualified plan would be $50,300 in inflation-adjusted dollars; by age 80, the advantage would grow to $252,300.

We estimate that tax deferral adds about 1.6% a year to the value of qualified plans—a significant benefit. In general, employees should invest as much as possible through a qualified plan, if available, before investing in a taxable portfolio. The earlier in life that employees begin contributing, the greater the benefits they reap.

The Bernstein Wealth Forecasting System uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.