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Taxable Vs. Tax-Deferred Investment Growth
The difference between taxable vs. tax-deferred investment growth can be substantial, but it can also be difficult to quantify without a calculator.
The mathematical reality is tax deferral will help you achieve your retirement goals more quickly, but there is a price to pay in terms of government regulation and sometimes higher fees associated with tax-deferred investing.
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You must weigh the growth benefits of tax-deferred investing against these costs to decide the best tax structure for achieving your financial goals.
Fortunately, this Taxable vs. Tax-Deferred Calculator makes the math easy so you can quickly find the right answer.
Below is analysis of each investment choice to help you make the decision…
Earned income is taxable every year, but exceptions exist. Taxable investment income includes:
- Capital gains
Most investment income is treated as ordinary income – taxed at your current tax rate. Gains on sales of long-term assets – held for more than a year – are generally taxed at the advantageous long-term capital gains rate.
Most tax-deferred investments reside in retirement accounts. Tax-deferred investments only pay taxes when investments are liquidated or sold.
Some equity investments, like stocks, can be considered tax-deferred investments. Although you may pay taxes on dividends, you will not pay taxes on market gains until sold.
Traditional retirement accounts are tax-deferred. Some government savings bonds also allow you to pay taxes on interest earned or defer tax payments until the bonds mature.
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Taxable Investment Advantages
Surprisingly, there are advantages to taxable investments that must be considered when formulating your investment plan:
- Invest more – There is no limitation to the amount you can invest in taxable investments; whereas, retirement plans have limits on annual contributions.
- Withdraw anytime – You don’t need to worry about penalties when withdrawing money from taxable investments (except in rare instances like certificates of deposit). Retirement accounts are subject to various penalties for premature distributions.
Remember: Retirement accounts have additional regulations – consult a financial expert.
Deferred-Tax Investment Advantages
Tax-deferred investing delays income taxes on investments until you withdraw money resulting in the following advantages:
- Grow quickly – The money you would have paid to the tax man stays in the account and continues to work for you earning additional return. More principal means more money to grow.
- Less immediately taxable income – Easier on your pocketbook and current financial situation.
Always remember that the value of your tax deferral is determined by your tax bracket.
Similarly, if you believe you might fall into a higher tax bracket later then it might make sense to pay the the taxes now rather than defer them to a higher tax bracket later.
Before deciding, compare investment options using the Taxable vs. Tax-Deferred Investment Growth Calculator. It will tell you which strategy provides the best future value?
Whichever account you choose, remember that you will still be paying taxes. Don’t put off taxes simply because you prefer to live lavishly now. Likewise, don’t pay taxes now in the midst of a dire financial situation. Make your decision using math – not emotion.
Regardless of the tax implications you should make sure to maximize contributions now to secure your retirement later.
Contribute early and often so you can watch your savings grow!
Taxable Vs. Deferred Tax Savings Terms & Definitions
- Taxable – Savings contributions taxed prior to deposit so only the net amount is invested.
- Tax-deferred – Savings contributions taxed upon withdrawal from an investment.
- Amount invested – Total contributions to your investment accounts.
- Expected annual rate of return – Yearly percentage growth you expect from your investments.
- Number of years invested – How long your contributions remained invested.
- Marginal tax rate – The tax rate paid applied to your next dollar of income (as opposed to the effective tax rate which is total taxes divided by total income).
- Investment return that is taxable – The percentage rate of expected return from investment that is taxable.
- Future value – The value of your investment in nominal dollars after the number of years invested.
- Annualized yield – The rate of return calculated as an annual rate.
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