Pre-Tax vs. After-Tax Returns

In January 30’s post I showed how the most valuable feature of tax-favored retirement plans is their tax exemption, compared to investing inside ordinary taxable investment accounts. How do you assess that value as you weigh the pros and cons of contributing to a tax-favored retirement plans? The two most important factors influencing that value are: (i) time (how long before you must distribute dollars from the plan?), and (ii) return differential (what is the difference between your pre-tax rate of return and your after-tax rate of return?). In today’s post I want to give some thought to the second factor.

In the example in January 28’s post, Ralph and Ed were in the 30% tax bracket during their working years. I asked you to assume that their investments earned 7%, but that Ed’s investment returns, being outside the shelter of a retirement plan, were shaved down to 5.3%. Where did that come from?

Wouldn’t it be better to assume that if Ed is in the 30% tax bracket, his investment income would be shaved by 2.1 percentage points (= 30% x 7%), down to 4.9%? No, Kemosabe, it would not. Why not? I’m glad you asked.

Shaving Ed’s return by his tax rate would be accurate enough if all of Ed’s investments were in the form of taxable bonds and other interest-bearing investments. But how likely is that? It’s more likely to be invested in a mixture of asset classes, with more complicated tax treatment. Consider all these complications:
• To the extent invested in municipal bonds, the appropriate differential is determined by the difference in interest rates between taxable and municipal bonds, as dictated by the financial markets and not Ed’s tax bracket at all.
• To the extent invested in stocks, a big component of Ed’s expected return is appreciation in value, which is not taxed at all until there’s a sale of the stock.
• When there’s a sale of appreciated stock, that appreciation is turned into capital gain, and Ed will have to pay tax on that gain. But the Feds give us a break and impose a lower tax rate than Ed’s 30% if the gain is long-term (i.e., the stock was held more than a year). Currently the federal rate is 15% or lower. That huge break may not hold for very long, but it’s a safe bet that long-term capital gain will continue to receive some sort of favorable treatment.
• And capital gain is very lumpy. It’s realized in chunks as Ed chooses to sell appreciated stock, unlike interest and dividends, which are taxed smoothly as they accrue. With capital gain, you can easily end up with a big tax bill in a money-losing year simply because that’s the year you choose to sell and reap prior years' appreciation.
• Under current tax law, built-in appreciation that has not been realized (by a sale of the stock) disappears at death and doesn’t get taxed at all. Well, actually the appreciation doesn’t disappear—just the taxation of it. (That particular rule is scheduled to change in 2010, but I have a feeling Congress and Obama will opt to retain the existing rule when it acts to reinstate the federal estate tax.)
• Currently, dividends are taxed at a preferential rate, like long-term capital gain, which is another complicating factor. Although it does not seem likely that will continue beyond 2010.

So if you invest a portion of your taxable account in anything other than taxable bonds, it is likely that your after-tax investment return will be somewhat greater than the number you would get by simply reducing your pre-tax rate of return by your tax rate. There will be some remaining differential, however, and that will be a big factor in determining the benefit you can expect from housing your savings in a tax-favored retirement account.