Practical Investing: Why I Pay Taxes Now

As advisers start offering year-end tax-planning suggestions, it seems to be an appropriate time to discuss the relative merits of taxable and tax-deferred accounts. I have both, but I prefer investing in taxable accounts—in defiance of conventional wisdom that says I shouldn’t. When advisers urge me to put my highest-yielding assets in tax-deferred accounts, I cringe. I’d just as soon pay the tax now.

I can hear the collective gasp of disbelief from advisers (and many wise readers) who have studied analyses that show how much more you’ll have in retirement if you avoid paying tax today. I don’t dispute the math, but I take exception to some of the assumptions. Look closely and you might, too.

Go-To Options

Before we proceed, let’s first establish that I fervently advocate investing as much as you can in a 401(k) or similar retirement plan—particularly if your employer provides matching contributions and good investment choices. The upfront deductions make contributing to these accounts relatively pain-free, and the matching contributions turbocharge your returns. The next-best option is a Roth IRA, which doesn’t provide upfront benefits but allows tax-free withdrawals in retirement.

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But if you’ve contributed all you can to a Roth—the maximum is $5,000 for those under 50—and you don’t get an employer match for your retirement plan (or don’t have a retirement plan at work), the only difference between a taxable account and a tax-deferred account is whether you pay tax now or later.

Mathematical illustrations that show how your money will grow in a taxable account compared with a tax-deferred account support the conventional wisdom, which says it’s always better to pay tax later. By paying tax later, you get to invest more now and watch your money compound over time.

At least that’s the way it’s supposed to work. But anecdotal evidence suggests that most people don’t actually invest the extra money they save when they put off paying the tax bill. Instead, they live a little better—they go out to dinner, buy clothes or “invest” in a big-screen TV.

And that throws the math in those illustrations out the window. In order to show that you save more with a tax-deferred account, the formula must start with an assumption that a person with a taxable account saves less by paying income taxes out of the account, thus reducing the year-end balance that gets reinvested.

For example, if you earned $8,000 for the year on a $100,000 account in a taxable portfolio, the formula would assume that you’d pay, say, $1,600 in tax on the gain and have just $106,400 reinvested after paying Uncle Sam. (To keep things simple, let’s ignore state and local taxes, as well as differences between capital-gains and ordinary-income tax rates.) The person with the tax-deferred account, however, would have the full $108,000 to reinvest. Thus, this formula shows the person with the taxable account entering retirement 20 years later with just $346,000, while the tax-deferred investor has $466,000. Of course, the tax-deferred investor must pay tax on this income in retirement and, assuming the same bracket and gains, would pay out $73,000 of the difference but still have $393,000 after tax, or $47,000 more.

But here’s the question: Do you pay taxes on investments out of your account, or do you find the money to pay them elsewhere—out of your annual income, for instance? If the latter, your taxable account will be worth $466,000 in retirement, too—and you won’t still owe the tax on your gains, making you richer in retirement. Of course, you probably would have lived a little more frugally during your more-youthful years because you had to pay more tax out of pocket. But aren’t your working years when you can best afford to do that?

Kathy Kristof is a contributing editor to Kiplinger’s Personal Finance and author of the book Investing 101. Follow her on Twitter. Or email her at practicalinvesting@kiplinger.com.

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