To encourage individuals to save for retirement, federal tax policy provides various tax advantages for investments in such accounts as traditional and Roth IRAs, and 401(k) plans. However, because different tax rules apply depending on the account, it can be difficult for individuals to choose where to put their money and, once they have begun to accumulate assets, to evaluate how much they will have available in retirement.
The Center for Retirement Research at Boston College has just published an eight-page Issue in Brief, "Saving for Retirement: Taxes Matter," that examines how taxes affect both the rate of return and the value of assets in various types of accounts.
The author, John M. Poterba, a professor of economics at the Massachusetts Institute of Technology, concludes that "in virtually all cases, $100 of earnings generates a higher return if it is invested in some form of tax-deferred account rather than a taxable account."
With respect to the rate of return comparison, a 401(k) contribution with an employer match, whether it is invested in bonds or in stocks, consistently has a higher after-tax return than the same contribution to any other type of account considered, although its advantage diminishes over time.
In comparing traditional and Roth IRAs, for individuals with constant tax rates the two vehicles have identical after-tax returns for any given pre-tax return. However, if an individual has a higher tax rate in retirement, the Roth IRA has a higher return. Conversely, if an individual faces a lower tax rate in retirement, the traditional IRA is a better bet.
The Issue in Brief is written for a reader with a fair knowledge of investment principles and terminology. To download it in PDF format, go to: http://www.bc.edu/centers/crr/issues/ib_17.pdf
(If you do not have the free PDF reader installed on your computer, download it here.)