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.
2 thoughts on “Taxable Vs Tax-Deferred Growth”
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.