Tax Deferred vs Taxable Retirement Income Strategies, Take 2 – A Much More Substantial Difference!

One of the great things about running a personal finance blog like mine is that sometimes you think you’re right about something.  So you publish it.  And then you find out very quickly from your audience that you could have done a much better job!

Just before Halloween, I published what started out as my valiant attempt to challenge the belief that investing in a 401k plan is the better of the retirement income strategies when you compare it to a regular taxable stock-based account.  In case you haven’t read it yet, please feel free to check it out here.

While I thought I had put forth a good effort, I was humbly delighted to receive a number of comments that pointed out several flaws with several of the assumptions I used to reach my conclusions.  After looking more deeply into a few of the more constructive comments, I decided it was worth it to correct my wrongs and give this exercise another go!

I’d like to extend an especially big thanks to reader Lucas for all the guidance he provided on helping to get these calculations right.  I believe this time around the model will be far more realistic and indicative of what would actually happen in real life.  And as we’ll discuss towards the end, that could have serious consequences on how we decide our save our money going forward!

Why Care So Much About the Difference Between These Retirement Income Strategies?

Even though I mentioned my rationale in the first post, I feel it’s important enough to bring up again.

Why care so much?  Well, first of all: Because it’s MY money!

I see investing in taxable stock market accounts as being an absolute critical element to a successful early retirement plan.  As you probably know, you can’t access your 401k or tax-sheltered plan without penalty until you are age 59-1/2.  That’s not very helpful if you plan to retire in your 50’s or 40’s.

So my goal to all this is to find out: What would happen?

If I invest in one versus the other, will it make that big of a difference?  Will I cheat myself out of hundreds of thousands of dollars?  Will I completely sabotage my retirement later on in life?

As the number one person looking out for my family’s financial well-being, I believe these kinds of things are incredibly important when you’re picking the right retirement income strategies to go with.  You owe it to yourself to do the best things for yourself that you can.

Let’s Begin – Defining Our Model’s Variables:

So similar to our example from before, you’ve got two choices:

1. Invest $17,500 per year (before taxes) in a taxable account that we’ll use for retirement savings
2. Invest $17,500 per year (before taxes) in a tax-sheltered retirement account (like a 401k)

To help re-build our model, we’ll need to make the following assumptions.  Note that some of them have been revised from the first post we did:

• Assume we’re a married couple filing a joint return (tax status).  You could also assume that $17,500 in savings is a combination of your savings (perhaps $8,750 from your account and $8,750 from your spouse’s).
• Unlike last time we will adjust for inflation using a 3% annualized rate.  By doing this and putting the model into net-present dollars, we can make things easier by assuming the same retirement contribution each year, the same retirement withdrawal, etc.
• Throughout the entire model we’ll be using the tax rates from 2013.  Obviously there is always the possibility that the tax rates will change throughout the years.  But since none of us can accurately predict what they will or won’t be 10, 20, 50 years from now, for now we’ll stick to what the current policies are.
• During your working years (pre-retirement), you’ll be in the 25% tax bracket with a modified adjusted gross income (MAGI) between $72K-$146K.
• Throughout the entire model using both methods we’ll assume all of our investments are the same and will make an average annualized 9% return (such as a low cost stock market index fund).  After taking in the 3% inflation, this will reduce down to 6%.
• After 30 years of working and investing, we’ll declare retirement in year 31.  Retirement contributions will cease.
• During retirement we’ll withdraw $48,000 per year ($4,000 per month) before taxes for living expenses.  For the sake of illustration we’ll keep this withdrawal the same in both strategies; though we will also later in the post look at what they would be if you used the conventional 4-percent retirement withdraw rate.
• Also during retirement, assume the kids have moved out of the house by then and can no longer be claimed as dependents on your income tax return.

Pre-Retirement – The Taxable Model:

The first thing to consider is that when you say to yourself you have $17,500 to save in a tax-sheltered account, that would actually be only $13,125 in the taxable account.  That’s because when you compare the two, you get to save it at your maximum marginal tax rate based on ordinary income.  In this case, that’s at 25%.

$17,500 x (1 – $25%) = $13,125

(Or you could also say $4,375 lost to taxes)

Taxes on Dividends:

As suggested by Matt Becker, you’ll still owe taxes on your qualified dividend payments.  On top of that you’ll probably also have a little bit of rebalancing going on.  To quantify this, we’ll also take 3% of our total savings balance and pay the 15% capital gains tax rate on it.

Pre-Retirement – The Tax-Sheltered Model:

Things are simple on this side.  Since you don’t have to pay any taxes on your contributions yet, the entire $17,500 just goes directly into the investment balance.

The Post-Retirement Years – The Taxable Model:

During retirement, going the Taxable route is actually the easier one to compute.  In our model since we are taking out $48,000 per year to live on and all of this income is coming from long-term capital gains / dividends, we’ll owe 0% in taxes!  This is because we have not yet exceeded the MAGI threshold of $72,500 where we then start paying 15%.

A minor point: The dividend income and capital gains from rebalancing would also not likely push us above the $72.5K MAGI threshold.  So our tax rate will still remain at 0%.

The Post-Retirement Years – The Tax-Sheltered Model:

Now here’s where things get fun.  Again thanks to reader Lucas for helping me to get this correct.

Remember that our U.S. tax system is a progressive one.  So the taxes we pay will be based on various tiers or levels.

In our model we are withdrawing $48K from our savings for living expenses.  Tax-sheltered income such as money you’d receive from a 401k plan is taxed as ordinary income.

The first thing we get to do is subtract a standard deduction and any personal exemptions.  In 2013, these figures were a one-time number of $12,200 and $3,900 for each dependent ($7,800 for you and your spouse).  Therefore our taxable income would be:

$48,000 – $12,200 – $7,800 = $28,000

Taking a look at the tax rates for ordinary income, we would calculate our taxes as:

$17,850 x 10% = $1,785

($28,000 – $17,850) x 15% = $1,523

$1,785 + $1,523 = $3,308

Notice how this figure is A LOT lower figure ($3,308 / $48,000 = 6.9%) than the 25% taxes we paid in the taxable model!

Another minor but subtle point: Because we are now no longer working and our savings is the only place that we can withdraw from to pay the taxes we owe, we’ll subtract the tax balance from our total savings balance each year.

The Results – The Difference Is Pretty Substantial!

Taking in all these facts on how to calculate the taxes properly, inflation adjustment, and so on, does one investment strategy reveal itself as being more compelling than another?  You bet!

Here are the results:

As you might guess, the tax-deferred strategy wins.  And it wins by a long shot – both at the time of retirement and way out in the future (in our example 30 years after retirement).

What does this mean for you and me?  Not only could we possibly live our entire lives with more wealth, but more importantly it means you’d be able to safely withdraw MORE money at the time of retirement and throughout your retired years.

To illustrate this point, let’s deviate from the $48,000 withdrawal figure we used in our example and instead use the conventional 4-percent withdrawal rule of thumb.  How much money would we be able to take out from our savings each year?

• Taxable account: $38,361 per year or $3,197 per month after taxes
• Tax-deferred account:$58,648 per year or $4,887 per month after taxes
• That’s a difference of $1,691 per month!  That’s no chump-change when you’re living on a fixed income.

Why Does the Tax-Deferred Strategy Win By Such a Long Shot?

Obviously the big advantage of a tax-deferred strategy is that you get to save more money during your working years (in our example at least $4,375 more each year).  More capital right from the beginning will help to compound into larger returns later.

But a more subtle point is the tax treatment during retirement.  Using the progressive tax system correctly, we can now see how we’re really only paying an average of about 7% taxes on our 401k plan during our retired years.  This is a HUGE difference from the 25% taxes we paid out during our working years on the money we saved in the taxable account.

These two things combined are what drives such a large gap between the retirement income strategies.

What Does This Do for My Retirement Plan?

Clearly this changes a lot for me and makes things harder.

My original conclusion was that there would not be such a large difference between the two and that giving up some of that tax-sheltering would be a small price to pay for the prospect of early retirement.

NOW I can see that the price-tag on early retirement just got substantially larger!  Say I was to go through with an early retirement by age 45 and used the taxable account strategy.  By our example I could be cheating myself out of a potential extra income of $1,691 per month!  That’s no small consideration.

If we look way out into the future I could potentially be costing myself almost $1.9 million dollars in accumulated wealth!  That is crazy to think about!

So now that we have a more believable financial model, we return to our original question: Is it worth it?  Can we in good conscious divert money from a tax-sheltered account to a taxable one for the sake of possibly taking an early retirement?  What do you think?

Related Posts:

1) Could Early Retirement Planning Be Ruining Me?

2) Your Plan for How to Become Financially Independent

3) How Do You Compare to the Average Retirement Savings of Other Americans?

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