The Value of Tax-Deferred Savings

Sometimes, we in the personal finance game are good at telling you what to do but not why. So much of our advice is obvious: Save your money, don’t take a payday loan and don’t buy derivatives with funny names. Well, duh.

It occurred to me, however, that I’m always telling people to take advantage of their 401(k), Roth IRA and other retirement accounts, whether or not they receive an employer match, but it’s far from obvious why this is such a good idea. In fact, it wasn’t entirely obvious to me until I went through the math.

If you don’t want to tiptoe through the garden of numbers with me, I completely understand. The take-home message is: Unless you make enough money to max out all of your tax-advantaged accounts (401(k), IRA, 529, HSA, and the like), it rarely makes sense to do any investing outside them.

Meet Alice and Bob

Let’s invent two hypothetical investors, Alice and Bob. Alice has a 401(k) with no employer match. Bob uses a regular taxable brokerage account for his retirement savings. Both are in the 25% tax bracket.

This year, Alice and Bob can each afford to save $10,000 in take-home pay. That means Alice can put $13,333 in her 401(k), because she doesn’t have to pay the 25% income tax on that money before contributing it. Meanwhile, Bob pays his tax and puts $10,000 into his brokerage account. Here are the standings:

2011
Alice	$13,333
Bob	$10,000

It looks like Alice is ahead, but she’s not, because her money hasn’t been taxed yet and Bob’s has.

Now let’s assume, for simplicity’s sake, that poor Alice and Bob never make another contribution, but their money compounds at 5% per year for 30 years. Ah, the future! Let’s take a look:

2041
Alice	$57,626
Bob	$30,175

Hmm, it seems like Alice is further ahead but maybe it’s still an illusion, because she hasn’t paid her taxes yet. Let’s go ahead and have Alice withdraw her money and pay the 25% tax.

2041 (After taxes)
Alice	$43,219
Bob	$30,175

Alice still wins. Why? Because Bob got taxed earlier and more often than Alice: Taxes cut into his returns, year after year, and he paid taxes on both his original contribution and the interest he earned on it. If Alice drops into a lower tax bracket in retirement, as people often do, she wins even bigger.

Hey, wait a minute!

I hope you’ve thought of some objections to this oversimplified analysis, because I sure have.

If Bob is investing in stocks, he isn’t going to get taxed every year— only at the end, like Alice, because you don’t pay capital gains tax until you sell.

Good point. Furthermore, long-term capital gains tax rates are generally lower than income tax rates. Sounds like Bob should keep his stocks out of his 401(k), right?

Not so fast, buddy.

First, stocks pay dividends. If you hold an S&P 500 index fund, for example, it’s currently paying 2% in dividends. You have to pay tax on those dividends every year (bonds that pay interest are taxed even higher).

Second, Bob still gets taxed twice. Say Bob buys a stock market fund that pays no dividends and all of his earnings come from capital gains. Again, he makes 5% per year for 30 years. At the end of 30 years, before he sells, he has $43,219, of which $10,000 is his original investment and $33,219 is capital gains. If the capital gains tax is 15%—less than Bob’s income tax rate—his after-tax balance comes to $38,236. Alice still cleans his clock.

But when you put money in a retirement account, it’s locked up until you’re 59.5 years old. I don’t want to lock my money away. I might need it.

Fear not: There are plenty of ways to get at your money early without a penalty.

-If the money is in a Roth IRA, you can always withdraw your contributions, tax-free and penalty-free.

-You can withdraw up to $10,000 per person from a traditional IRA for a first-time home purchase.

-You can take money from a 401(k) at age 55 if you separate from your employer.

-You can take a 401(k) loan.

-If you retire early, you can take what the IRS mellifluously calls “substantially equal periodic payments,” or, even more memorably, a “72(t) election,” and start withdrawing from a 401(k) or IRA with no penalty, as long as you continue doing so indefinitely.

-You can withdraw without penalty for a variety of hardships.

-If the money is in a 529 plan, which is very similar to a Roth IRA for tax purposes, you can use it at any time for qualified educational expenses.

-Best of all, I’d argue, if you regret contributing too much to your retirement accounts (not a common problem), you can pause your contributions, spend more of your money now, and resume contributing later.

Money for nothing

These tax-advantaged accounts are like free money from the federal (and, in many cases, state) government, year after year. It’s similar to an employer match, although admittedly not as lucrative.

If you’re not maxing out your 401(k) because you can’t afford to, or because you’re building up an emergency fund or saving for a near-term cash outlay like a house or car, or because you’re paying down debt, that’s perfectly reasonable.

But if you’re putting investments (or cash) in a taxable account for an unspecific future goal while your 401(k) or other retirement accounts languish unfulfilled, you’re just throwing away money.

Could you kick a little extra into one of your tax-advantaged accounts before the 2011 deadline? For workplace retirement plans and 529s, the deadline is December 31; for traditional and Roth IRAs and Health Savings Accounts, it’s April 17, 2012.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.