The Difference in Pre-Tax versus After Tax Investing
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.
|Year||Age||Cash Contribution||Taxes||Fund Value||Before-Tax Yield||Pre-Tax Return||Post-Return Tax||After-Tax Yield||Retirement Income|
|Year||Age||Cash Contribution||Taxes||Fund Value||Before-Tax Yield||Taxes||After-Tax Yield||Income||Taxes||Retirement Income|
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.