KJ: Not all savings are created equal. This point is very important, so I felt that this topic warranted its own post entirely. Consider the following chart comparing a Roth IRA versus a regular, taxable, savings/investment account (meaning a regular investment account at Scottrade, TD Ameritrade, eTrade, Charles Schwab, Fidelity, etc.).(1)
The above chart illustrates how effective it can be to have your money compound over time while not having to pay taxes on it! The differences are quite substantial when you run the numbers to see what makes sense from a long-term planning perspective. The longer you are able to defer the taxes (or eliminate future taxes as is the case with a Roth), the greater that tax advantage is on your portfolio(s).
There are three primary types of accounts from a tax perspective:
1) Taxable accounts – an account where the realized gains and income generated during the year are taxable in the current year. This could include savings, money markets, CDs, and regular investment accounts with a brokerage firm. It is particularly beneficial for short-term savings ranging from an emergency fund, one year goal, twenty year goal or supplemental retirement savings. You have the most flexibility to use these funds for that vacation you’ve been planning for.
2) Tax-deferred accounts – an account where the owner is able to deduct a portion (or all) of the contributions from their current taxes, but has to pay taxes in future years when money is withdrawn. This could include a Traditional IRA, SEP IRA, tax-deductible 401(k), and many Profit Sharing Plans. It is beneficial for retirement savings when you expect to be in a lower tax bracket in retirement than you are today.
3) Tax-exempt accounts (2) – an account where the owner does not pay annual taxes on gains/losses or income and additionally does not have to pay taxes on any distributions from the account. However, the owner is also not typically able to deduct contributions made to the account for income tax purposes. This could include Roth IRAs, HSAs (under certain circumstances – an HSA can be both tax deductible AND tax-exempt if used for medical expenses), Roth 401(k), and 529 plans. It is beneficial for retirement savings where you plan to be in a higher tax bracket in retirement or for monies you intend to pass to another generation.
From this analysis, it may sound like it would make sense to put all of your money into a Roth. However, it can be useful not to put all your savings into just one type of account from a tax perspective. It is useful to use a combination of taxable accounts, tax-deferred accounts, and tax-exempt accounts to diversify your assets from a tax perspective since tax rates change, restrictions and potential IRS penalties vary by account type, and your income may fluctuate over time. Especially for long-term assets tagged for retirement, tax-exempt (i.e. Roth) accounts can be quite attractive compared to a regular savings or investment account!
(1) Assumptions include: $200 monthly savings starting at age 25 and continuously until age 75; 7% average rate of return; 15% tax on capital gains and 25% tax on ordinary income. The taxable accounts assume that half of the account gains are derived from capital gains and the other half from ordinary income. There are many factors that could cause this split to be meaningfully different. The 100% turnover scenario assumes ALL gains/income generated in the year are taxable in that year as compared to the 75% turnover scenario which assumes 75% of the gains for the year are taxable. Actual returns realized and assumptions may be meaningfully different and do not present an offer or guarantee that the returns could be attained. State taxes (if applicable) were excluded from the analysis. If included, they would effectively reduce the after-tax portfolio at each interval.
(2) Not all accounts listed are tax-exempt in all circumstances. Consult a financial advisor for clarification on scenarios where the account may not be tax-exempt.
Some of the links in the post above may be affiliate links. This means if you click on the link and purchase the item, we will receive an affiliate commission. We feel strongly about only recommending products or services we use personally and/or believe will add value to you, our readers. Read more about our commitment to providing quality product recommendations.