We’re all told that we should use IRA and 401k accounts to save for retirement due to their great tax benefits. But how valuable exactly are those benefits? 🤔 A huge difference? A little difference? This Morningstar article crunches some numbers for “traditional” pre-tax IRA/401ks within a broadly-representative tax situation and three example portfolios. (Although the benefits should be basically the same for Roth accounts, as they end up assuming the same tax rate during the working and retirement years.)
A one-time $5,000 contribution (pre-tax) is invested for 40 years within both the tax-deferred IRA/401k and a taxable brokerage account. The three example portfolios are “100% zero-dividend stocks”, “100% stock index”, and “60% stocks/40% bonds balanced” – essentially most to least tax-efficient. All are assumed to return 8% annually. Here are the results:
Here is the conclusion, quoted directly from the article:
To address this article’s original question, for investments made over a full working career, from age 25 to 65, IRA/401(k) accounts improve the final aftertax value of the study’s assets by 17% for a no-dividend portfolio, 30% for a stock market index fund, and 44% for a low-turnover balanced fund. Those figures, of course, will vary according to personal circumstances, but I conducted enough offscreen spreadsheet tests, using different tax brackets, to conclude that they are broadly representative.
As you might expect, the advantage is greater when the portfolio is less tax-efficient. The more something spins off dividends, capital gains, or interest, the more it should try to go in the tax-deferred bucket.
If you assume the use of the most popular target date retirement funds, they are 90% to 100% stock market index for the majority of the working years (25-65). So there you have it. A 30% boost is a reasonable estimate for most people to carry around in their heads. Roughly 1/3rd more. That’s a lot!
In short, IRA/401(k) plans are a very good deal. And should the latter offer a company match, they become a truly great deal.
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40 Years!?! I guess having parents who are into this is your best bet for you. I mean as long as they’re not do concerned about just making ends meet.
25 to 65 is 40 years.
If you contribute at 35 and withdraw at 75, that’s also 40 years. And so on.
We put $5,000 into a Roth Ira (Vanguard total market) for our daughter at 18. She never touched it and is now worth about $40K (she is now 42). The rule of 72 does work. I figure when she retires it will be worth about $150K tax free.
Did she have income? I thought Roth IRA is only for income earners?
It’s good to see the benefits quantified. My wife and I have been diligently contributing to our tax-advantaged accounts (TSP, 403(b), and Roth IRAs) for over 20 years, but I’ve changed things up recently. My wife has accumulated almost $900k in her 403(b), but with no matching contributions or a Roth option, we’ve begun diverting those funds to a taxable brokerage to avoid the inevitable tax problems with RMDs and possibly fund early retirement. Is there anything we’re potentially missing out on by eliminating those 403(b) contributions at this stage of the game?
I would investigate converting some to Roth if you are worried about RMDs. If you’re already opting to pay taxes now, you might as well turn some of your balances into a Roth with no RMDs.
Thanks for the response. I’m thinking about Roth conversions, but to my knowledge, neither employer offers any in-service options to do so. At lease one of us would need to retire early, so I’m thinking that increasing our taxable brokerage assets could also provide us with funds to help with Roth conversions.
In that case, why not pick Roth 403b/401k instead?
Alas, she doesn’t have a Roth 403b option available to her.
Really! In 2024, that’s rather surprising.
I guess that’s what happens when you’re a public school teacher…
This article must assume that the investor is using funds directly from the taxable account to pay taxes? Also, I guess I’d rather lock in paying taxes now at historically low rates rather than defer taxes to be paid at a later date at what I believe will be a much higher rate.
Something I’ve been needing to decide between is traditional 401k vs ROTH 401k. Researching online, I see arguments in favor of both sides. Where do you stand on this question?