Tax Exemption for Investment Earnings

In Wednesday’s post, we summarized the three main benefits of traditional tax-favored retirement plans. Of the three, which do you think is most important? Surprisingly, for most people, it’s the tax exemption on investment earnings compounding within your savings bucket. So powerful; so under-appreciated.

Let me recap the big three, chronologically.
• Deduction up front, giving you more to invest.
• Tax-exemption on investment earnings, allowing them to compound at a higher rate of return
• Tax bracket arbitrage, allowing you to pay income tax at your (presumably lower) post-retirement income tax bracket

Which do you think is most important? Most people like the deduction. It has a lot of surface appeal, because you immediately see the tangible result. You feel wealthier. Remember the example of Ralph and Ed from Wednesday’s post? Because of the deduction, wise Ralph had $6,000 to invest and Ed only had $4,200. The deduction is the sizzle that sells the steak. It’s easy to forget that the $6,000 comes with a built-in income tax liability that will bite back when you go to spend it in the future. Don’t get me wrong. It’s a good thing for sure. But not as powerful as the tax-exemption.

What about tax bracket arbitrage? Trading your high working year tax bracket for your low retirement year tax bracket? In yesterday’s post, we pointed out that for many people who are striving to get their Future Selves into the same standard of living as their Present Selves, tax bracket arbitrage is an illusion. They may well be in the same tax bracket—or even higher. And if it turns out to be a higher tax bracket, have they done their Future Selves a disservice?

Nosirree Bob! Because they still will have benefitted from the account’s intervening tax-exemption, the Mighty Mouse of retirement planning!

How powerful might that be? Again, remember the example of Ralph and Ed from Wednesday’s post. Ralph ended up with annual after-tax retirement spending of $2,790 compared to Ed’s $1,377. Let’s do a thought experiment. Let’s leave all other facts the same, but pretend Ralph’s account gets no tax exemption, so his account earns the same rate of return as Ed’s (5.3% during their working years, and 5.5% during their retirement years). Then Ralph’s annual after-tax spending drops from $2,790 to $1,475, a mere $98 per year more than Ed's. Our thought experiment shows that Ralph’s savings bucket’s tax exemption accounts for 93% of his benefit to be gleaned in real life!

So when you’re doing your planning, don’t make the mistake, as I so often see in the press, of focusing only on pre- and post-retirement tax brackets or the glamorous tax deduction. It’s the humble tax exemption, taking advantage of the miracle of compounding, that’s really doing the heavy lifting.