Before I get into taxable versus tax-deferred growth of your capital, I’d like to point out a blog I stumbled upon called The Corner Office which provides a great resource to prep for your visit to the tax man.? Here is the pdf you should review before seeing your accountant as it can help save you a few hundred dollars in prep time.? Now on to the impact of taxable investments.
John Chow says it best when he said the “number 1 rule is to always think after tax” when looking for investment opportunities.? I agree.? Tax-deferred growth makes a huge difference when looking years down the line.? I created the below comparison to give you an idea of the impact:
An example of a Tax-Deferred investment is your 401K and your Traditional IRA.? An example of a Fully Taxable investment is your individual, joint, or trust account; and an example of a Tax-Free investment is a muni bond you purchase in an otherwise taxable account.? When comparing these investments after 20 years of growth, the taxable accounts really take a hit.? This is why a truly disciplined investor who is planning for their future would choose to max out their tax-deferred accounts.? I say “max out” because there are annual limits to your 401K and IRA contributions.? Even with the tax hit when you withdraw tax-deferred money, the growth still out-performs taxable accounts.?
In summary, the best things the majority of people can do for themselves are:
- Open and max out their 401K (assuming you have a company match)
- Open and max out their Roth IRA (you contribute after tax income so the growth is tax free)
- Contribute to other retirement accounts
- Invest in taxable accounts
I don’t mention tax-free accounts because if you are in a situation where muni bonds make sense for you, then you are probably already aware of the advantages and disadvantages.? The return on tax-free investments are also significantly lower than the historical returns on stock investments; however, they are risk free. The best advice I can give you is to open and max out your 401K and Roth IRA accounts as soon as you can.? The younger the better.
Does this example take into account that growth in taxable accounts may max out at 15% and withdrawal from tax deferred accounts is taxed as regular income? At current tax rates for capital gains and qualified dividends, I am no longer sure that investing in tax deferred accounts really makes sense.
Thanks for this interesting article. I have the same question as Charles. If I basically have a long-term buy and hold strategy on a tax-efficient index fund like Vanguard Tax-Managed growth and income, which tracks the S&P 500 and tries not to pay out dividends, then I wouldn’t I be better off paying the 15% capital gains tax on the gain in a taxable account rather than having it grow tax-free but have to pay 33% marginal rates on ordinary income? I’m interested in what people have to say about this.