One of the keys to logical thinking is not to miss the forest for the trees. Sometimes focusing on one aspect of a problem you have to solve, no matter how important, can cause us to miss the big picture. This can be the case in financial advice, also, particularly when it comes to tax-advantaged retirement accounts.
It’s a common refrain: how much in tax dollars you could save by contribution to your 401(K) plan. As financial advisors, we certainly do spend some time thinking about how clients could save on taxes, either now or in the future, depending on the type of retirement account into which they save.
Do they go with a traditional 401(K) or IRA, in which your contributions are tax-deductible now, even if you have to pay taxes on withdrawals in the future? Or should they go with a Roth-designated account, in which contributions are not tax-deductible, but their future withdrawals will be?
Do we want to save on taxes now, or later? Do we expect tax rates to be higher now, or in the future? What if we have maxed out our Roth contributions?
Or, how about this one: if future taxes will be higher, might it even make more sense to just open a taxable account instead of a tax-deferred one so that withdrawals in the future are not taxed? Why not avoid the requirements to wait until 59 ½, avoid the penalties, avoid the required minimum distributions and all those IRS rules?
If that last one sounds strange to you, it should: it’s missing the forest for the trees and promising a world of hurt if you try to parachute down into that morass.
What these kinds of rabbit-holes forget is this: we don’t save for retirement to avoid paying taxes. Not now, not in the future. Saving in tax-advantaged accounts is a good thing—but it’s not why we should save.
Saving has several definitions, but here is one we like to consider at Emergent: saving is consumption deferred. What does that mean?
We consume throughout the course of our lives. Sometimes that is necessary consumption: we need to eat! Sometimes it is for pleasure or personal satisfaction: we like to go on vacation, or buy a book, or take up pottery and gardening classes.
Before retirement, when we are working and generating income, the calculation is simple: we consume based off the income we have. More income, more consumption. But if we never saved, then when retirement comes (or some age at which we wanted to work less), we would suddenly have to consume less. In such a scenario, we could never retire completely at all!
So we make a tradeoff. We trade some of the consumption we might have had today, and save that money for tomorrow. We invest it so that it will grow, so that $1 saved today might actually be worth more than $1 tomorrow.
Tax-advantaged accounts like the 401(K) help us do this not primarily by avoiding taxes today or tomorrow, but by helping ensure that the growth of our savings is not eaten away by taxation.
Let’s look at some numbers!
Imagine a very simple retirement scenario where you save $6000 a year for 10 years, then stop saving and let the results grow for the next 30 years until retirement. We’ll assume a modest 6% growth rate annually.
In your basic 401(K), these savings will grow without taxes hindering that growth, to a total of about $481,000 by Year 40. At that point, will you have to pay income taxes on the money you take out? Yes, indeed.
Well, what if taxes in the future are higher than taxes now? Why not put the money in a taxable account, not a 401(K), so that we can avoid those future income taxes? After all, better to pay 15% taxes on $6000 contributed to a 401(K) now, than to be 25% on $6000 pulled out in 30 years, right? All true.
Here is where we would lose the forest for the trees.
Because that means that the growth of our savings might be taxed, also.
Now imagine that in our taxable account, we save the same amount ($6000 a year for 10 years), get the same 6% annual return—except now we have to pay that 15% tax on our earnings every year.
That still has to be better than paying 25% at the end, right?
Not if the tax drag has anything to say about it. The tax drag is the accumulated effect of not just a tax paid on earnings but of the future compound interest that will never happen because of the amount that was taxed away.
That taxable account would end up having just about $354,000 in it after Year 40, a $127,000 decrease. So, how much of our savings did we sacrifice by trying to save 10% in taxes (25% – 15%)?
The answer is 26%. That’s the power of the tax drag.
Now, you might argue that this assumes our 6% return is taxed every year, whereas capital gains (this is when you sell a stock, as opposed to just receiving a dividend or bond interest) are only taxed when sold.
So let’s assume a halfway-approach. Assume that, each year, only half of our return is in interest (3%), while the other half is in capital gains that we, magically, never pay because we never sell any stocks. This would, of course, mean no rebalancing, no adjusting our portfolio, which would hardly reflect real life, and, of course, if we ever wanted to touch the money, we would have to pay those capital gains taxes. But we’ll be generous in our example.
What do we end up with, then? The answer is $413,000, or about a $68,000 drop from our 401(K) example.
In this case, we would lose about 14% of our value, all for trying to save 10% in taxes.
That’s the power of the tax drag that holds back our compound interest, which, as have discussed in previous blog posts, is what Einstein called “the most powerful force in the universe.”
If it sounds like a poor idea to hold back the most powerful force in the universe from helping our savings grow, that’s because it is.
So, what should be the big takeaway from our experiment? It’s not that using legal and valuable means to reduce your taxes is a bad thing. Savings plans like IRAs and 401(K)s exist, and are tax-advantaged, for that very reason: to help people save.
Rather, it is that, in our zeal to “avoid taxes,” we must never confuse that as the point of saving. Because confusing those two aspects of saving can lead to some serious consequences.
Alex Urpi, CFA