The Difference in Pre-Tax versus After Tax Investing

Posted on September 20, 2011 by Bill Faiferlick

Is there a benefit in deferring taxes today to only pay taxes at the same rate later on?

This is often a question not only of the client but often a CPA’s response as well.
Certain assumptions made by CPA’s are causing their clients to pay considerably more in unnecessary taxes than absolutely necessary. Frequently CPA’s give verbal instructions which are based on personal opinions rather than on substantive reasoning or factual data. We must assume the CPA advice is well intended, but frankly often their advice just falls short under close scrutiny, and here’s why.
First of all the CPA is making one huge assumption, the client on their own will routinely make sizeable consistent contributions for retirement. Statistics indicate otherwise. Secondly, the most frequent response why successful people don’t make large retirement contributions is because they’re told they can’t. For many the size of the savings doesn’t warrant the effort. Yet the staggering dollar amount of capital or investments needed at retirement allowing us to live for another 20-30 years for practically everyone is shocking. This will be further examined below.
Examining the numbers:
A client is currently living on $200,000 of taxable income and wants to be able to maintain their lifestyle. The client will need $5,537,692 in cash at the onset of retirement to be able to fund only a twenty-year retirement. For thirty years, the need increases to $7,484,728, after which in either scenario all the money is spent. Remember these amounts are needed at the onset of retirement. One major consideration we’ve ignored is health care costs. Assuming you will live the rest of your years without any major medical or health care issues and long term coverage is optional, then the numbers work. If health care as an expense is included then you will need to increase the accumulation goal by at least $500,000 per person.
What is closer to what most people will actually experience?
Regardless of individual desires, most people will have to settle for a more modest retirement and lifestyle, due to the lack of accumulated assets or wealth. With a desired pre-tax retirement income of $100,000 per year and a life expectancy of 20 years the accumulated amount would have to be $2,768,846, and with a life expectancy of thirty-year you’ll need $3,742,364. After actively working with people for two decades, what I see is that regardless of income levels, few individuals are anywhere close to being on track. Where we as a population seem to think the money will come from is a mystery to me.
What is the most efficient method of accumulating capital without taking the next ten to fifteen years to do so?
Working longer is always an option, but certainly most of us want the option not to have to. What is frequently overlooked regardless of how long a person will work is unanticipated health issues. Suddenly the opportunity for continued work isn’t possible. In these circumstances, unless there are already millions tucked aside there will be a liquidation of other assets at some future date.
What’s the fastest way to accumulate the largest amount of cash in the shortest time? The answer is, eliminate or greatly reduce what you are spending in the form of unnecessary tax payments to the federal government. By eliminating or greatly reducing those quarterly or annual payments and depositing them directly into your plan you accelerate your net worth without additional labor by no less than 40%. Add tax deferred growth and compounding and your account balance will in a few short years accelerate to a sizeable amount. The chart below compares after tax investing against pretax accumulation. Note: given the same net income which scenario runs out of money first?
Here’s what each chart reflects:
There is the same contribution in both except one is after-tax and the other is a pre-tax contribution. Both charts assume an annual 10% return for each contribution year. The glaring difference is with the after tax chart we continued the 10% assumed rate of return until all the money was paid out. The pretax chart illustrates that once distribution occurred, the rate of return was reduced down to 5%, meaning the after tax chart has a huge advantage.
Both charts reflect a 40% tax rate.
In the after tax chart you will notice the Pre-Return Tax column, we are allowing there will be some tax each year on the accumulation due to dividends, unrealized capital gains, etc.
In the tenth year we pay out the same net distribution for each chart. Notice in the pre-tax chart that in the tenth year there is already $700,000 more in the fund column than with the after tax column. Moving to age 78 the after tax column is out of money, while the pretax chart continues to deliver a constant income for another decade.
Investing After-Tax Dollars
Year Age Cash Contribution Taxes Fund Value Before-Tax Yield Pre-Tax Return Post-Return Tax After-Tax Yield Retirement Income
2004 53 180,000 72,000 108,000 10,800 4,320 - 6,480 -
2005 54 180,000 72,000 222,480 22,248 8,899 - 13,349 -
2006 55 180,000 72,000 334,829 34,383 13,753 - 20,630 -
2007 56 180,000 72,000 472,459 47,246 18,898 - 28,348 -
2008 57 180,000 72,000 608,806 60,881 24,352 - 36,528 -
2009 58 180,000 72,000 753,334 75,333 30,133 - 45,200 -
2010 59 180,000 72,000 906,534 90,653 36,262 - 54,392 -
2011 60 180,000 72,000 1,068,927 106,893 42,757 - 64,136 -
2012 61 180,000 72,000 1,241,062 124,106 49,642 - 74,464 -
2013 62 - - 1,315,526 119,553 - 47,821 71,732 120,000
2014 63 - - 1,267,257 114,726 - 45,890 68,835 120,000
2015 64 - - 1,216,093 109,609 - 43,844 65,766 120,000
2016 65 - - 1,161,858 104,186 - 41,674 62,512 120,000
2017 66 - - 1,104,370 98,437 - 39,375 59,062 120,000
2018 67 - - 1,043,432 92,343 - 36,937 55,406 120,000
2019 68 - - 978,838 85,884 - 34,354 51,530 120,000
2020 69 - - 910,368 79,037 - 31,615 47,422 120,000
2021 70 - - 837,790 71,779 - 28,712 43,067 120,000
2022 71 - - 760,858 64,086 - 25,634 38,451 120,000
2023 72 - - 679,309 59,931 - 22,372 33,559 120,000
2024 73 - - 592,868 47,287 - 18,915 28,372 120,000
2025 74 - - 501,240 38,124 - 15,250 22,874 120,000
2026 75 - - 404,114 28,411 - 11,365 17,047 120,000
2027 76 - - 301,161 18,116 - 7,246 10,870 120,000
2028 77 - - 192,031 7,203 - 2,881 4,322 120,000
2029 78 - - 76,353 0 - 0 0 76,353
2030 79 - - 0 0 - 0 0 0
Investing Pre-Tax Dollars
Year Age Cash Contribution Taxes Fund Value Before-Tax Yield Taxes After-Tax Yield Income Taxes Retirement Income
2004 53 180,000 0 180,000 9,000 0 9,000 - - -
2005 54 180,000 0 369,000 18,450 0 18,450 - - -
2006 55 180,000 0 567,450 28,373 0 28,373 - - -
2007 56 180,000 0 775,823 38,791 0 38,791 - - -
2008 57 180,000 0 994,614 49,731 0 49,731 - - -
2009 58 180,000 0 1,224,344 61,217 0 61,217 - - -
2010 59 180,000 0 1,465,562 73,278 0 73,278 - - -
2011 60 180,000 0 1,718,840 85,942 0 85,942 - - -
2012 61 180,000 0 1,984,782 99,239 0 99,239 - - -
2013 62 - - 2,084,021 94,201 0 94,201 200,000 80,000 120,000
2014 63 - - 1,984,782 177,822 0 177,822 200,000 80,000 120,000
2015 64 - - 1,956,044 175,604 0 175,604 200,000 80,000 120,000
2016 65 - - 1,932,648 173,165 0 173,165 200,000 80,000 120,000
2017 66 - - 1,904,813 170,481 0 170,481 200,000 80,000 120,000
2018 67 - - 1,875,294 167,529 0 167,529 200,000 80,000 120,000
2019 68 - - 1,842,824 164,282 0 164,282 200,000 80,000 120,000
2020 69 - - 1,807,806 160,711 0 160,711 200,000 80,000 120,000
2021 70 - - 1,767,817 156,782 0 156,782 200,000 80,000 120,000
2022 71 - - 1,724,598 152,460 0 152,460 200,000 80,000 120,000
2023 72 - - 1,677,058 147,706 0 147,706 200,000 80,000 120,000
2024 72 - - 1,624,764 142,476 0 142,476 200,000 80,000 120,000
2025 74 - - 1,567,241 136,724 0 136,724 200,000 80,000 120,000
2026 75 - - 1,503,965 130,396 0 130,396 200,000 80,000 120,000
2027 76 - - 1,434,361 123,436 0 123,436 200,000 80,000 120,000
2028 77 - - 1,357,797 115,780 0 115,780 200,000 80,000 120,000
2029 78 - - 1,273,577 107,358 0 107,358 200,000 80,000 120,000
2030 79 - - 1,180,935 98,093 0 98,093 200,000 80,000 120,000
2031 80 - - 1,079,028 87,903 0 87,903 200,000 80,000 120,000
2032 81 - - 966,931 76,693 0 76,693 200,000 80,000 120,000
2033 82 - - 843,624 64,362 0 64,362 200,000 80,000 120,000
2034 83 - - 707,986 50,799 0 50,799 200,000 80,000 120,000
2035 84 - - 558,785 35,879 0 35,879 200,000 80,000 120,000
2036 85 - - 394,664 19,466 0 19,466 200,000 80,000 120,000
2037 86 - - 214,130 1,413 0 1,413 200,000 80,000 120,000
2038 87 - - 15,543 0 0 0 15,543 6,217 9,326
2039 88 - - 0 0 0 0 0 0
The conclusion: the numbers accurately reflect without bias what someone might actually expect to accumulate over a few years. It correctly shows what has widely been known for decades. Any time you have the use of not only your money but Uncle’s portion as well, and you include tax deferred compounding there really is no way but to out-perform pre-tax investing. To come close with after tax investing you would have to have had in excess of a 20% return each and every year without any market fluctuations. Remember we also gave the advantage of excess returns during the distribution phase to the after-tax column as opposed to the lower 5% return in the pre-tax column during the distribution period. Even then the after-tax lags far behind.
It’s safe to assume not all situations lend themselves to this form of accumulation for a variety of reason. Knowing this, there are strategies which will work to help accelerate and secure the amounts you wish to invest. Knowing what drives and motivates you to work and live, to support whatever lifestyle you have is at the core of all planning opportunities. There are other options.