The Real Value Of An IRA: The Magic Of Tax Deferred Compounding by Dirk Leach
A recent Sure Dividend article entitled “What Is The Fastest & Best Way for a Working Class Person To Become a Multi-Millionaire?” discussed that discipline, mindset, and the magic of compounding returns was all that was needed to accumulate $1M.
The compounding of interest or returns really isn’t magic, but it is one of the realities that comes close to being magic. I came to realize that many investors did not fully understand the magic of compounding, particularly tax deferred compounding, when I published a recent article entitled “The Best Investment of Your Lifetime That You Can Make Today” which discussed the importance of taking advantage of tax deferred retirement plans.
This article presents a comparison of compounding for non-taxed deferred investments, compounding inside a traditional IRA, and compounding in a ROTH IRA and provides conclusions about the real value of tax deferred compounding.
Future Value of a Series of Deposits
Initially, I wasn’t able to find a web based calculator that would also handle the tax liability. So, to generate the comparisons for this article, I translated the equation for the future value of a series of payments below into an EXCEL spreadsheet along with a couple of equations to track the taxes due on the earnings.
After having spent a couple of hours developing the spreadsheet and doing the simulations, I happened across exactly the canned calculator for which I was initially searching. The calculator uses the same basic future value formula along with a tax liability calculator. For those wanting to run their own simulations, that calculator can be found here.
Is Tax Deferred Compounding Really Important?
The short answer to that question is, yes.
The long answer is presented below in the comparisons between non-tax deferred compounding, tax deferred compounding in a traditional IRA, and tax deferred compounding in a ROTH IRA.
The first example we will review are investments that compound with taxes being paid annually on the earnings.
Example 1: Edward Smart is a young professional making about $75,000 per year. Edward and his spouse, Edwina, file their taxes jointly and are in the 25% tax bracket. Edward wants to start saving and investing for retirement but is not convinced that IRA’s are the best option. Edward is worried that the tax code may change and he doesn’t like all those rules that come with IRAs. So, Edward starts a regular savings and investment plan where he invests $400 per month in a REIT based mutual fund that historically has returned 9% before inflation. Edward thinks that inflation should be on average about 2% and Edward will be making these deposits over the next 35 years until he retires. This is what Edward would have at retirement after taxes assuming that Edward remains in the same 25% tax bracket for those 35 years.
Edward and Edwina would have a bit more than $480K at retirement. While it probably won’t provide Edward and his wife a lavish retirement, it is a tidy sum none-the-less. Edward paid taxes each year along the way and so, at retirement, his nest egg of $480,641 is tax free. But, as can be seen in the table, Edward will pay a total of more than $104k in taxes on the annual earnings by the time he retires.
Example 2: Edward’s little brother, Joe Smart, is roughly in the same situation as Edward except that Joe talked to an investment advisor about IRA’s and tax deferred compounding and his plan is to invest $400 monthly in a traditional IRA using a similar REIT mutual fund that pays 9%. Because of the extra power of tax deferred compounding, Joe’s retirement nest egg is looking a little better than Edward’s.
Wow! Joe’s plan will net him an additional $94k at the end of 35 years and the only difference is that Joe made his regular investments in an IRA so he didn’t have to pay taxes on the earnings every year and those extra dollars continue to work for him.
Those extra earnings boosted Joe’s total return even assuming that Joe would be in the 25% tax bracket in retirement. Not only did Joe get the benefit of tax deferred compounding, he saved a total of $42,000 on his taxes over the 35 years by deducting his IRA contributions. Joe’s nest egg of $574,488.75 is based on Joe having to pay 25% of his IRA account total ($709,985) to the IRS with his tax savings of $42k added back in. This is clearly a better deal than his older brother Edward is getting.
Example 3: What if Joe’s retirement tax bracket is only 15%? The table below shows that Joe’s after tax future value would be even higher.
Joe’s nest egg would be roughly another $70k higher if, in retirement, Joe’s tax bracket dropped to 15%. Maybe Edward could learn something about the value of tax deferred compounding from his little brother Joe.
Example 4: Joe and Edward also have a cousin, Ebenezer Smart. Most of Ebenezer’s coworkers have ROTH IRA’s and after some research, Ebenezer decides he should do likewise. Ebenezer likes the idea of the ROTH IRA as he is worried that the tax brackets will creep up on him over this 35 year working career. So, he’d like to pay the taxes on his deposits now and not have to worry about that later. Ebenezer puts into his ROTH account the same $400 per month that Joe puts into his traditional IRA. Given the same type of investment returns and inflation assumptions as Edward and Joe, this is what Ebenezer’s ROTH IRA nest egg would contain after 35 years.
Remember that Ebenezer has to pay income taxes at a marginal rate of 25% on the money he is depositing in his ROTH IRA account just like Edward did for his non-tax deferred account and Ebenezer gets no deduction for his ROTH IRA contributions. But, the tax deferred compounding and not having any taxes due on the withdrawals during retirement are really a significant benefit. It appears that old Ebenezer is the smartest of the extended Smart family.
The additional benefits of a ROTH IRA are not without some added rules. The ROTH IRA comes with some additional deposit aging requirements as well as different early withdrawal regulations versus traditional IRA accounts. Readers are urged to spend some time on the internet understanding the rules and regulations that govern both traditional IRA accounts and ROTH IRA accounts before making a decision about which one to use.
Clearly, in almost all cases, a tax deferred retirement plan will beat a non-tax deferred retirement plan hands down. The only possible caveat to that would be if the investor is in the very bottom tax brackets (0 – 15%) during their accumulation years but finds himself in one of the highest brackets (35% – 39.6%) at retirement. This would be a very unlikely scenario.
ROTH IRAs have a significant advantage for most investors because there is no tax liability at withdrawal of the contributions or the earnings for qualified withdrawals. The benefit of a ROTH IRA over a traditional IRA will be reduced for situations where the investor is in the top tax bracket during the accumulation phase and a low tax bracket at retirement. Because of the variability of individual’s tax situations throughout their careers and into retirement, I urge investors to exercise one of the many available calculators on the internet before making a decision about the best tax deferred retirement option for their individual situation.
Finally, experienced investors will recognize that the investment examples in this article were chosen to allow as close to an apples to apples comparison of the results after taxes. Clearly, an experienced investor in Edward’s shoes might choose other alternative investments that would lower his tax burden. Alternative investments might be stocks or mutual funds that pay qualified dividends or focusing on growth stocks and long term capital gains which are both taxed at a lower rate than ordinary income. For a more complete discussion on the tax treatment of ordinary income, qualified dividends, and long term capital gains, an article on the subject can be found here.
The tax code allows for very favorable treatment of qualified retirement plans. Everyone who qualifies to participate in a qualified retirement plan should make every effort to do so.