Quantifying the Value of Retirement Accounts

Quantifying the Value of Retirement Accounts

Many people talk about the tax benefits of retirement accounts. However, few attempt to quantify and estimate the actual benefits.

To make matters worse, when the topic is addressed, many of the discussions rely on flawed logic and do not properly measure the true benefit.

For example, I often hear investors (even investment and tax professionals) summarize the core benefit as being due to “tax deferral.” In my view, however, deferring taxes is not the primary benefit of using retirement accounts. Moreover, deferral can actually work out to the detriment of investors, since overall tax rates can increase and investors can move into higher tax brackets by the time they must pay their taxes.(1)

This article highlights what I believe to be the real golden goose behind retirement accounts. In particular, there is immense value in not having to pay taxes on investment income and rebalancing (i.e., dividends, interest, and capital gains).(2) I attempt to quantify this benefit for a variety of portfolio strategies and tax brackets via historical simulations.(3)

Spoiler: While the results are dependent on market performance and each investor’s tax bracket, my calculations indicate the tax benefits of retirement accounts range between 0.7% and 2.7% per year.(4)

Overview

If one uses Google to search for the phrases “tax benefits of retirement accounts,” or “value of tax deferral,” the results are mixed.(5) Among the varied topics in the search results, you will find much sponsored and marketing content, many irrelevant discussions, and plenty of financial jargon. At best I found some relevant but generic discussions with anecdotal examples. However, this was buried among articles with flawed logic and outright false claims (some from sources I thought reputable).

I cannot rule out the possibility that my Google search skills may just need improvement. However, I knew what I was looking for and still could not find it succinctly presented – let alone anything outlining a sensible general framework for decisions around funding retirement accounts. This was my motivation for writing this article.

My goal here is to provide a simple framework investors, as well as investment (or even tax) professionals, can leverage in order to make sensible decisions around funding retirement accounts. In particular, I quantify and estimate the relative value of dollars used to fund retirement accounts versus those invested without the tax benefits.

It is worth noting that retirement accounts have other advantages and disadvantages. For example, assets within retirement accounts are generally better-protected from creditors than if they were held outside retirement accounts. However, there are also liquidity constraints and early withdrawal penalties. I do not address these or other issues here for several reasons. For example, they are only occasionally relevant and are difficult to quantify.  However, the overriding factor is that I would like to keep my framework as simple as possible by focusing on what I find to be the most valuable benefit (which I refer to as the real golden goose).

This article has four sections and a short conclusion. The first section discusses the deceptive nature of the term tax deferral when used in the context of retirement account benefits. The second section highlights what I believe drives the real value of using retirement accounts – the ability to avoid paying taxes on investment income, rebalancing, and growth. I then quantify this benefit via historical simulations in the third section. There are a number of variables that affect the results (tax rates, portfolio strategies, etc.). So I provide results across multiple scenarios. The fourth section discusses the relevance of the results and highlights practical examples where investors and related professionals can leverage these results to make better financial planning decisions.

Tax Benefits versus Tax Deferral

There is some confusion surrounding the tax benefits of retirement accounts. I suspect some of this is due to them being described as tax deferral benefits. I regularly hear investors and tax professionals use this description and you can find many instances of this around the internet and other media. Some highlight the benefit of reducing current income, and hence taxes, when making contributions to a retirement account. Some point out the likelihood of paying more taxes down the road when using retirement accounts (since the investments will appreciate and they will pay taxes on more income when it is taken out).

These two views are opposite sides of the same coin. In this context, funding a retirement account can be viewed as a choice between paying fewer taxes now or more taxes later. The link that ties them together is the time value of money. For example, one could contribute to their IRA to reduce their current (income) tax bill and then invest those tax savings. In this case, they should have more money to pay the higher tax bill down the road.

If we assume we can invest at the same rate of return within or outside of a retirement account, then the economic decision to fund a retirement account or not hinges on whether one’s income tax rate will be higher or lower when the money is taken out. If they are the same, then the math works out identically and it makes no difference; you will end up with the same amount of money whether you contribute or not (see Figure 1).

Figure 1: To Fund or Not to Fund a Retirement Account

Source: Aaron Brask Capital

If overall tax rates rise or the investor climbs into a higher tax bracket, then it is possible for the deferral to work against them. Of course, tax rates and future tax brackets could work to the benefit of the investor as well. These details should be considered in order to better measure the benefit or detriment of tax deferral. Notwithstanding, there is still one appreciable detail I have left out. Above I relied on the assumption that we can invest at the same rate of return inside or outside of retirement accounts. However, that is definitely not the case. The next two sections should make this abundantly clear.

The Real Golden Goose of Retirement Accounts

In the example scenario highlighted in Figure 1, there are two details (aside from the tax rates) that make a significant difference between the dollar amounts at the end of the period. First, the dollar invested outside the IRA embeds unrealized capital gains at the end of the period. In order to spend that money, the investor will have to pay capital gains taxes.(6) Second, it is unrealistic to assume one could achieve the same returns outside of an IRA versus within. If nothing else, the dividend and interest payments would trigger taxes. Moreover, rebalancing a portfolio could also result in capital gains taxes during the investment period.

This highlights what I believe to be the most important benefit of retirement accounts: the ability to avoid paying taxes on the dividends, interest, and capitals gains while they reside within a retirement account. At current prices, the dividend yield of the overall US stock market is a little over 1.5% and the 10-year treasury yield is just under 3%. If an investor pays 15% tax on dividends and an income tax of 25%, then a typical 60/40 portfolio would currently pay about 44 basis points in tax per year on the investment income.

Of course, yields on stocks and bonds are near historic lows right now. Thus the tax impact on this investment income is much lower now than it has been in the past. Moreover, this does not include any additional taxes incurred from rebalancing the portfolio to maintain the 60/40 weightings, nor liquidating the portfolio in cases where the money is to be spent. The next section describes the historical simulation I built to make these calculations and displays the results across a variety of scenarios (portfolio mixes, tax rates, glide paths, etc).

Pièce De Résistance(7)

Some Assumptions

I use rolling 20-year periods between 1968 and 2018. So this analysis is based on 30 sample periods – many of which are overlapping. I simulate portfolios with buy and hold, fixed asset allocation, as well as glide path strategies.(8) Rebalancing is implemented annually. I use the S&P 500 benchmark for equity allocations and the performance of 10-year Treasury bond for the fixed income allocations.

I use conservative assumptions regarding the tax consequences of rebalancing and capital gains distributions.(9) I assume optimal tax lot selling when rebalancing (i.e., highest basis holdings sold first). I also assume the benchmarks generate no capital gains distributions (we can thank the tax efficiency of exchange-traded funds for this feature).

Lastly, I assume dividends and interest payments are received at the end of each year. Of course, this does not precisely reflect reality. However, it should not alter the results significantly. The assumption is made for both the taxed and untaxed portfolios (retirement account) and we are primarily interested in the relative results.

The Results

The results I present are based on historical simulations of portfolio performance. My goal is to quantify the tax benefits of the retirement accounts. So I express these benefits as the difference between the annualized total returns of the portfolios held within and outside of retirement accounts.(10)

I calculate results for both liquidated and non-liquidated scenarios. The liquidated portfolio scenario is relevant to situations where investors end up spending the money (capital gains will apply to the realized gains for portfolios outside of retirement accounts). The non-liquidated portfolio scenario would be relevant to cases where the investor does not need to access the money. For example, it could remain invested until being inherited or donated to a charity and benefit from a step-up basis – hence avoiding capital gains on the unrealized gains.

I run the simulations across three dimensions: strategy type, risk level, and tax rates. As mentioned above, there are three types of strategies: buy and hold, fixed asset allocation, and glide paths.

For each strategy, I observe four different risk levels by varying the stock and bond allocations (80/20, 60/40, 40/60, and 20/80). Within each of these risk levels, I analyze the impact of both moderate and high tax brackets.(11)

Here are some of the key findings:

  • For liquidated portfolios, the benefit ranged from 1.1% to 2.7% and averaged 1.7% across all scenarios.
  • For non-liquidated portfolios, the benefit ranged from 0.7% to 2.7% and averaged 1.5% across all scenarios.
  • Strategy trends
    • Buy and hold strategies with no rebalancing benefited the least with an average differential of 1.5% – presumably due to less tax friction from rebalancing.
    • Fixed asset allocation strategies were in the middle with an average differential of 1.6%.
    • Glide path strategies benefited the most with an average differential of 1.8% – presumably due to increased rebalancing (higher equity growth versus falling equity allocations).
  • Lower risk (i.e., stock) allocations benefited the most with an average differential of 2.0% for 20/80 portfolios versus 1.2% for 80/20 portfolios. Delving deeper into the tax benefits reveals the income tax on the bond coupons drove this trend.
  • The obvious trends across tax rates materialized (i.e., higher tax brackets benefit more). The average differential for the moderate tax bracket was 1.3% versus 1.9% for the high tax bracket.

I suspect there are many investors pursuing a 60/40 fixed asset allocation approach that falls within the moderate tax bracket I used here. In this particular scenario (see Figure 7 below), the tax benefit of retirement accounts averaged 1.3% for liquidated portfolios and 1.1% for non-liquidated portfolios.

There are, of course, many ways to slice and dice these results.

Below are several bar charts that make comparisons across different dimensions. However, I have also provided tables containing all of the results for those interested in other comparisons.

Figure 2: Average Benefit across Strategies

Source: Aaron Brask Capital

Figure 3: Average Benefit across Risk (stock/bond %)

Source: Aaron Brask Capital

Figure 4: Average Benefit for High vs Low Tax Bracket

Source: Aaron Brask Capital

Figure 5: Average Benefit for Liquidated vs Non-Liq.

Source: Aaron Brask Capital

Figure 6: Buy and Hold Strategies

Source: Aaron Brask Capital

Figure 7: Fixed Asset Allocation Strategies

Source: Aaron Brask Capital

Figure 8: Glide Path Strategies

Source: Aaron Brask Capital

Some Applications

The above analysis provides a means of quantifying the tax benefits of retirement accounts. These results can be considered in various aspects of financial planning, but I believe the most important takeaway is for investors to establish and maximize contributions to retirement accounts such as IRAs, 401Ks, etc. More generally, investors should try to maximize the longevity of these tax benefits where possible since the benefit compounds with time.

For starters, a good rule of thumb is to spend money outside of your non-retirement accounts first so the tax benefits can accrue longer. However, Roth-type accounts should also be considered (whether via contribution or conversion). This could extend the tax advantages by avoiding required minimum distributions. Moreover, leaving IRAs to younger heirs (e.g., children or grandchildren) with longer expected life spans can extend the longevity of these benefits even further. Of course, investors considering such strategies should weigh the impact of what income tax rates will apply.

Another topic related to the tax benefits of retirement accounts is asset location. In particular, once an asset allocation is prescribed, it is sensible to consider which assets should be placed within the retirement accounts versus outside. While this is an important consideration and should be integrated into the financial planning process, it is beyond the scope of this article. Indeed, asset location is a rich topic and depends on a variety of factors (e.g., types of accounts, tax efficiency of assets, expected returns, time horizon, whether funds are likely to be spent during one’s lifetime or not, etc.).

The notion of tax benefits is also relevant to annuities. Indeed, financial professionals selling these products often highlight their tax advantages. The results I quantified above can help evaluate the cost/benefit of these tax advantages. It is worth noting the earnings accrued within annuities are taxed as income when the funds are removed. So the deferral benefit will likely be offset by the higher taxation of those earnings as income (relative to capital gains if they were incurred outside a retirement account). In my experience, the fees of annuity products (especially variable annuities) often outweigh their tax benefits. As a result, I believe investors interested in annuities should be specifically interested in the products’ non-tax-related benefits (e.g., asset protection or other riders) in order to justify their costs. However, I generally find it is possible to construct more cost-efficient solutions. I provide a more detailed discussion of these concepts here.

The last application I mention here relates to net unrealized appreciation (NUA) transactions. Without going into the details, employees who own significantly appreciated stock in their company retirement plans have two options; they can take the stock out of their retirement plan and place it in a brokerage account or roll it into an IRA. There are advantages and disadvantages related to both options, but weighing the tax benefits of the IRA is naturally a relevant consideration.

Maximizing the utility of retirement accounts involves many other variables I have not discussed here – potential need for early withdrawals, desire for asset protection, potential changes in laws regarding tax treatment, etc. Moreover, many of these factors should be addressed in a holistic fashion to optimize each investor’s particular situation. I hope that by quantifying some of tax benefits of retirement accounts above, investors and other professionals will be able to leverage these results to improve their financial planning.

Conclusions

The tax benefits of retirements accounts range between 0.7% and 2.7% per year. However, the results vary across the different dimensions I considered and there are other variables to consider. Suffice to say, benefits on this order of magnitude can translate into tremendous value for investors. Thus it is wise to contribute to and maximize these retirement account benefits where possible.

This conclusion is both unsurprising and already well-known. However, I could not find any studies or research that quantified these benefits. So I hope my results can be helpful to others involved in financial planning where the value of these tax benefits is relevant and can impact decisions around their strategies.


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References   [ + ]

1. I don’t mention it here, but there is also the possibility that rules are retroactively changed. For example, investors with large retirement accounts might be told that there are tax penalties for amounts over some amount (e.g., $3mm).
2. Technically, these investment-related taxes are not deferred; they are simply not paid. However, in the case of an IRA the accumulated benefit of not paying these taxes may result in paying higher income taxes if/when the money is eventually taken out of the retirement account.
3. Disclaimer: I am not a tax professional. This article is not and should not be construed as tax advice. Investors should seek advice from a CPA or qualified tax professional for any questions or issues related to taxes.
4. Wes and his team find something similar, albeit via different assumptions/framework here.
5. Note: Unless otherwise stated, the retirement accounts discussed in this article are assumed to be individual retirement accounts (IRAs).
6. Capital gains taxes on the investment growth may not apply in cases where the investments are passed on to heirs or charities where they would typically benefit from a step-up basis. I provide results for both scenarios.
7. Disclaimer: This analysis is neither exhaustive nor precise. The following results are essentially the result of a mathematical exercise which relies on several simplifying assumptions.
8. Glide paths systematically reduce equity allocations by 1% per year.
9. To be fair, tax harvesting could potentially mitigate, if not eliminate, many capital gains taxes. However, the resulting portfolio would generally have a lower basis and trigger higher capitals gains when it is ultimately sold.
10. I compare the same portfolios inside and outside retirement accounts. However, an investor could employ an asset location strategy. That is, one could maintain the same overall asset allocation while allocating differently within versus outside retirement accounts. This diminishes the value of my results to some extent since the comparison assumes the same asset allocations in both the retirement and taxable portfolios. However, academic and practitioner white papers (Michael Kitces and Betterment highlight estimates here and here) seem to indicate the average asset location benefit is between 20 and 50 basis points. So the magnitude of my results below are still very relevant.
11. I assumed 15% (20%) dividend and long-term capital gains and 25% (39.6%) income tax rates for the moderate (high) tax bracket.

About the Author:

Aaron Brask
Aaron is an accomplished Mathematical Finance PhD who runs his own registered investment advisor (RIA) - Aaron Brask Capital LLC. Before starting his own firm, Aaron's last role was at Barclays Capital where he built and ran two global research teams focused on quantitative equity and derivatives strategies for the firm's top clients. He has been published and quoted in major newspapers and magazines including the Wall Street Journal, Financial Times, Barron's, and Risk magazine. Aaron Brask Capital is an independent, fee-only registered investment advisor. That means I do not promote any particular products and cannot receive commissions from third parties. In addition to holding me to a fiduciary standard, this structure further removes monetary conflicts of interests and aligns my interests with those of my clients. In terms of spirit, my firm embodies my own ethics, discipline, and expertise. In particular, my analytical background and experience working with some of the most affluent families around the globe have been critical in helping me formulate investment strategies that deliver performance and comfort to my clients. I continually strive to demonstrate my loyalty and value to my clients so they know their financial affairs are being handled with the care and expertise they deserve.

11 Comments

  1. Tom Rinaldi April 20, 2018 at 10:12 am

    Aaron, I’ve noticed this importance of internal compounding as well. Personally, I have decided to set up a personal 529. Would be curious of your thoughts (and math sanity check!). It appears to me that even after paying back the (NY) state tax deduction (zero interest) and applying the penalty of 10% on gains that the IRRs will be equal if you assume 15% cap gains tax outside the 529 and 25% income tax inside the 529… that you can breakeven over a pretty short period of time. Further, the use of a 529 to fund adult education (cooking school, etc….) offers the opportunity to avoid taxes entirely. Even just using a fraction of the money toward an eligible expense, the net after tax IRR on the 529 can be much better than the unqualified taxable account.

    • Aaron Brask
      Aaron Brask April 30, 2018 at 11:46 am

      Hi Tom – Pardon the delayed response. I cannot comment on tax strategy or personalized advice, but I can confirm the math you alluded to is not insane! I recall reading about a similar strategy (HSAs) in Phil Demuth’s book ‘The Affluent Investor.’

  2. Tom Rinaldi April 22, 2018 at 3:24 pm

    I recently began funding a 529 for myself on your premise. Why did you use such a low dividend tax outside the qualified account? I assumed 15 cap gain, 30 percent dividend rates (marginal federal income rate). And then I assumed 25 tax on withdrawal from account and 10 percent penalty. It seemed to me that 15/35 spread could be overcome in15 years…. And that’s if NO success is had finding qualified educational expanses to spend the money on in retirement. Curious of your thoughts.

    • Aaron Brask
      Aaron Brask April 30, 2018 at 11:54 am

      I assumed *qualified* dividends which get the lower rate. My thinking was to make my assumptions conservative for measuring the tax benefit (~ less tax in the first place => less benefit when mitigated).

  3. Alex Xander April 27, 2018 at 9:40 pm

    You are correct that what the industry and experts claim to be the benefits of retirement account, are not. But you still don’t have it correct. I have been pounding the table on this for 10 years now. All this stuff is common to all TEE and EET accounts in all countries.

    You can find my work using the US situation at
    https://www.advisorperspectives.com/articles/2017/12/11/the-unambiguous-tax-deferred-retirement-account and at
    https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3042608 .
    The Asset Location question that maximizes the true benefits is at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2317970
    The step by step analysis of the Cdn equivalent of the US tradIRA (the RRSP) is argued at http://www.retailinvestor.org/RRSPmodel.html The differences in rules are pretty obvious and can be ignored, but the important stuff is the same.
    The spreadsheet that allows you to input whatever assumptions you like to prove my math correct is at http://www.retailinvestor.org/xlsxSecureCopy/Challenge.xlsx

    • Aaron Brask
      Aaron Brask April 30, 2018 at 12:12 pm

      Pardon the delay in responding and thanks for your feedback, but could you please point out where/why I am wrong? These results are pretty straightforward math based on historical simulations. How you apply or translate them is another issue.

      I looked at the first article you highlighted. It seems you acknowledge the benefit of retirement accounts (using a lower 4.7% return for taxable accounts vs 5.5% for retirement). Given enough time, this benefit can accrue significantly (even outweighing higher income tax rates). So your blanket statement (“The only factor impacting the traditional account’s net benefit, on which everyone agrees, is the difference in tax rates between contribution and withdrawal.”) is simply not true.

      On a related note, I see you let the $250 of current tax saving from the traditional IRA contribution grow at the higher rate of return (as if it were in a retirement account). That does not make sense unless there is a different motivation for the rates of return you are using?

      • Alex Xander May 5, 2018 at 11:57 am

        I am disappointed that you felt you could understand my work by reading just one article linked which of necessity glossed over the full rational.
        You object to the modelling of the $250 tax reduction on contribution shown on https://www.advisorperspectives.com/articles/2017/12/11/the-unambiguous-tax-deferred-retirement-account. 1) The point of my work is to find a conceptual understanding of ‘what is happening’ that perfectly explains and predicts exactly what the math calculation of net benefits will be. The Difference column is simply a math calculation = difference between Roth and IRA balances. 2) The $250 tax savings MUST always grow at the tax-free rate because both IRA profits and the Roth profits grow at tax-free rates.

        Your own article attempts to prove exactly the same point in the section called “TAX BENEFITS …” in the paragraph starting “If we assume we can invest at the same rate of return…” The tax reduction at the start fully funds the tax liability at the end … therefore it must grow at the same rate of return.

        3) You object to my supposed presumption that the $refund is actually inside the IRA. In the article I included the sentence “This model holds true regardless of actual cash flows” specifically to let readers know that I am aware of that argument, I have thought about, and found it to be false.
        (i) At http://www.retailinvestor.org/RRSPmodel.html you will find the models stated presumption to be that …” (a) when comparing the outcomes from using different accounts it is necessary to presume that all savings go into those accounts, (b) when wages and living expenses are held constant between options, any option that reduces taxes should result in larger savings, (c) the IRA’s benefits accrue only to the dollars in the account.”
        (ii) Everyone DOES get the tax reduction at whatever their tax rate is. It exists. Further down that page at http://www.retailinvestor.org/RRSPmodel.html#refund I show that it is irrelevant where the physical cash from an IRA contribution’s refund ends up.

        In your APPLICATIONS section I disagree with your statement. …”Investors should try to maximize the longevity of these tax benefits where possible since the benefit compounds with time.. . A good rule of thumb is to spend money outside of your non-retirement accounts first so the tax benefits can accrue longer..” This ignores the effect of different withdrawal tax rates now vs later.

        In your CONCLUSION section I disagree with your statement …”The tax benefits of retirements accounts range between 0.7% and 2.7% per year.” It is not possible to make this kind of generality. The net tax benefits could be NEGATIVE if the withdrawal tax rate (plus loss of retirement benefits) is large enough, or if in the choice between w/d now or later the time differential is short.

        In the REAL GOLDEN GOOSE section I disagree with your statement… “the ability to avoid paying taxes on the dividends, interest, and capitals gains while they reside within a retirement account.” Because you failed to look at what factors create the IRA’s benefits/costs you missed the most important understanding ….. that profits are not taxed ever, for anyone, not while inside the account and not on withdrawal.

        In your TAX BENEFITS section I disagree with your statement …”If overall tax rates rise or the investor climbs into a higher tax bracket, then it is possible for the deferral to work against them.” Because you failed to look at what factors create the IRA’s benefits/costs you missed the second most important understanding ….. that there are no benefits or costs ever ‘from deferral’. The word deferral refers to the passage of time. You attempt to distort the possible bonus/penalty from a difference in tax rates into something created by ‘time. But that change in rates can happen within a year. Or there may be no change in tax rates no matter how many decades go by.

        So you see that I disagree with you on the benefit from permanently sheltering profits from tax. And I disagree with you on the false benefit from deferral. The only point where we agree is on the issue of benefit/costs resulting from a change in tax rates.

        Of course single sentence arguments won’t change anyone’s minds. I ask that you read the body of work I have produced over the decade.

        • Wes Gray, PhD
          Wes Gray, PhD May 7, 2018 at 7:44 am

          Hey Alex, your post got snagged in our spam somehow…
          I’ll let Aaron respond. Good to see an intense conversation!

        • Aaron Brask
          Aaron Brask May 7, 2018 at 9:37 am

          Alex – I am sorry I disappoint you. The good news is that we are both after similar things here (modeling the advantages of retirement accounts) and math is the ultimate reconciliation tool once we agree on the assumptions.

          The problem, as I see it, is with your assumptions. In particular, you are comparing traditional vs Roth and my article mostly compares non-retirement account (same as column 1 “taxed” in your table) to traditional (IRA). These are two related but different analyses. In fact, my article really only attempts to isolate the tax benefits within the retirement accounts so they may be weighed against other items such as differing income tax rates (now vs later).

          This explains where most of your criticism comes from (conflating two different analyses) and this is why I questioned the rate of return on the $250 in your analysis (for me it was IRA or not, for you it was IRA vs Roth). Moreover, you seem to go out of your way to take statements out of context when I clearly address the issues within the article (multiple times).

          Following your #ing and your (my?) labels:
          #1-3: Explained by your apples-oranges comparison
          APPLICATIONS: See paragraph immediately preceding REAL GOLDEN GOOSE section. You are just ignoring my caveats and taking those comments out of context. You obviously have to weigh both considerations as pointed out multiples times in my article.
          CONCLUSION: Again, I am only quantifying the “deferral” benefits within the accounts. I highlighted the necessity of weighing in the potential impact of different income tax rates.
          REAL GOLDEN GOOSE: Please reread the section. This was precisely the point I made in this section. It was pointed out earlier in the article and made clear here – especially given the fact that I presented results for both liquidated and non-liquidated investments (money spent or not spent).
          TAX BENEFITS: Now you are just wasting time. I dedicated an entire section to pointing out the fallacious nature of such ‘deferral’ arguments.

          As for your analysis, even when I put the apples-oranges comparison aside, there are two more flaws in your assumptions:
          [1] Your model assumes taxes are paid with the money from a Roth. You need to broaden the model to include external funds to pay these taxes as your approach cannibalizes much of the benefit. Yes, this makes the analysis a little harder, but it is in the best interests of your clients.
          [2] Your model assumes a 30-year period after which the money is spent. This assumption also undermines the value of the Roth approach as those dollars often need not be spent and can thus enjoy the tax benefits for a longer time. I explained this in my APPLICATIONS section but this point seems to be lost on you.

          So please take a big breath and try to keep the toys in the crib so we can have a productive conversation here. Taking things out of context and comparing apples/oranges is a waste of time. Interestingly, Tom’s comments above regarding his personal 529 strategy reflect the essence of my article (thanks Tom – wish I included this example!). I suggest you read and digest his idea before replying. It is a perfect example as it weighs the value of the benefits I quantified (the main point of my article!) vs other factors (i.e., penalties).

          • Alex Xander May 7, 2018 at 11:46 am

            (1) You say “The problem is with your assumptions. In particular, you are comparing traditional vs Roth” That is factually false because I define and calculate ‘net benefits’ to be the difference in outcomes between the two retirement accounts VS THE TAXED ACCOUNT. Even if you only look at my picture you will see that calculated and deconstructed difference (net benefit) at the bottom for both retirement accounts vs the Taxed account.

            (2) You say “This is why I questioned the rate of return on the $250 in your analysis (for me it was IRA or not, for you it was IRA vs Roth)”. So why did you object to only the rate of return earned by the tax reduction, and not the whole Difference column?
            No. That is a misrepresentation of that first picture. The picture (which holds true for all variable inputs, contrary to your claim) provides a conceptual model and explains the math for calculating the net benefits of both retirement accounts VS. THE TAXED ACCOUNT. Importantly it breaks down the trad IRA’s net benefits into the factors that add up to the net benefit, and shows where those independent factors come from.

            Since I prove that the trad IRA’s benefits always include the exactly equal $benefit as the Roth (from permanently sheltering profits from tax) I use the picture to show ‘how that is possible’ – why ‘the tax events don’t impact’ the permanent profit sheltering of the after-tax savings within the trad IRA.

            (3) You say “Explained by your apples-oranges comparison”. False. My work is always apples to apples. You have not disputed my stated three premises that specifically require an apples to apples comparison. Nor do you give any evidence you read the detailed material I linked above showing that it makes absolutely no difference what exactly you do with any cash tax reduction … as long as you do not increase spending (one of my premises).

            (4) You say “Your model assumes taxes are paid with the money from a Roth.” False. That statement is incomprehensible to me. Even if all you looked at was that first picture, the Roth column does not show ANY taxes being paid at the end.

            (5) You say “Your model assumes a 30-year period.” Correct. The same period of time for all three accounts to allow for an apples to apples comparison. I do not disagree the rich people who do not need to spend their savings can extend the Roth’s profit sheltering. Those rich people could can also shelter capital gains over generations so the profit sheltering benefit of both retirement accounts would be largely zero’s out.

            But heck if you cannot accept the trad IRA’s main benefit is from permanently sheltering profit from tax, you won’t accept an extension of that same benefit.

            (6) You say ” I dedicated an entire section to pointing out the fallacious nature of such ‘deferral’ arguments.” But you never stated categorically that “There is never any benefit from deferral”. In order to re-educate all the misinformation promoted by the industry and experts it is critical that people be told point blank with no sugar coating that ‘Your understanding is wrong’. Until that position is taken readers will continue to just cherry pick their ideas from a list of falsely claimed benefits, according to the decision at hand.

            If you want proof of that just look at the review by Kites at https://www.kitces.com/blog/weekend-reading-for-financial-planners-apr-28-29-2/. He actually thought after reading this article that your conclusions regarding the trad IRA were …..”.”the benefits of tax-deferral really break into two separate categories: 1) the ability to get a tax deduction on contribution and pay taxes at the time of withdrawal (which amounts to deferring the taxes on the original earnings amount that was contributed until they’re subsequently withdrawn); and 2) deferring taxation on investment income itself””

            In reality, there is never any benefit from deferral. The tax reduction on contribution is never a benefit. You never benefit from being able to invest that $$ from the tax reduction in the mean time before repayment. The profits are not just deferred from tax – they are permanently tax free.

            (7) Nothing you have said indicates you have bothered to read any of the links I provided and only glanced (without understanding) the first picture of the first link. So I will leave the discussion here.

  4. Aaron Brask
    Aaron Brask May 16, 2018 at 9:04 am

    Alex: You are ignoring the points we agree on and still taking my comments out of context to fabricate issues and allege I am making factually incorrect statements. At this point, I do not believe this conversation is productive and only serves to distract from my main point (and the common ground we have). So I am only replying to one of your comments. However, if you (or anyone) would like replies to your other points, then please feel free to email me.

    [Regarding your quote from Michael Kitces] I have immense respect for Michael Kitces and his views. However, the comment you quoted from him regarding tax deferral does not reflect the points I made in my article. He started the statement you quoted with “In reality, …”. So that is his assertion and not mine. In fact, I would say ‘deferral’ is one area you and I (mostly) agree on. I cannot control other people’s interpretations or statements, but I will acknowledge the possibility I did not make my points clear enough.

    On that note, I have pasted in the last two paragraph’s of my opening section in an effort to help clarify *my* view on the ‘deferral’ issue (clearly highlighting some common ground we have on the matter) and reiterate the main point of the article:

    For example, I often hear investors (even investment and tax professionals) summarize the core benefit as being due to “tax deferral.” In my view, however, deferring taxes is not the primary benefit of using retirement accounts. Moreover, deferral can actually work out to the detriment of investors, since overall tax rates can increase and investors can move into higher tax brackets by the time they must pay their taxes.

    This article highlights what I believe to be the real golden goose behind retirement accounts. In particular, there is immense value in not having to pay taxes on investment income and rebalancing (i.e., dividends, interest, and capital gains). I attempt to quantify this benefit for a variety of portfolio strategies and tax brackets via historical simulations.

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