Quantifying The Value Of Retirement Accounts

Many people talk about the tax benefits of retirement accounts. However, few attempt to quantify and estimate the actual benefits.

To make matters worse, when the topic is addressed, many of the discussions rely on flawed logic and do not properly measure the true benefit.

For example, I often hear investors (even investment and tax professionals) summarize the core benefit as being due to “tax deferral.” In my view, however, deferring taxes is not the primary benefit of using retirement accounts. Moreover, deferral can actually work out to the detriment of investors, since overall tax rates can increase and investors can move into higher tax brackets by the time they must pay their taxes.(1)

This article highlights what I believe to be the real golden goose behind retirement accounts. In particular, there is immense value in not having to pay taxes on investment income and rebalancing (i.e., dividends, interest, and capital gains).(2) I attempt to quantify this benefit for a variety of portfolio strategies and tax brackets via historical simulations.(3)

Spoiler: While the results are dependent on market performance and each investor’s tax bracket, my calculations indicate the tax benefits of retirement accounts range between 0.7% and 2.7% per year.(4)

Overview

If one uses Google to search for the phrases “tax benefits of retirement accounts,” or “value of tax deferral,” the results are mixed.(5) Among the varied topics in the search results, you will find much sponsored and marketing content, many irrelevant discussions, and plenty of financial jargon. At best I found some relevant but generic discussions with anecdotal examples. However, this was buried among articles with flawed logic and outright false claims (some from sources I thought reputable).

I cannot rule out the possibility that my Google search skills may just need improvement. However, I knew what I was looking for and still could not find it succinctly presented – let alone anything outlining a sensible general framework for decisions around funding retirement accounts. This was my motivation for writing this article.

My goal here is to provide a simple framework investors, as well as investment (or even tax) professionals, can leverage in order to make sensible decisions around funding retirement accounts. In particular, I quantify and estimate the relative value of dollars used to fund retirement accounts versus those invested without the tax benefits.

It is worth noting that retirement accounts have other advantages and disadvantages. For example, assets within retirement accounts are generally better-protected from creditors than if they were held outside retirement accounts. However, there are also liquidity constraints and early withdrawal penalties. I do not address these or other issues here for several reasons. For example, they are only occasionally relevant and are difficult to quantify.  However, the overriding factor is that I would like to keep my framework as simple as possible by focusing on what I find to be the most valuable benefit (which I refer to as the real golden goose).

This article has four sections and a short conclusion. The first section discusses the deceptive nature of the term tax deferralwhen used in the context of retirement account benefits. The second section highlights what I believe drives the real value of using retirement accounts – the ability to avoid paying taxes on investment income, rebalancing, and growth. I then quantify this benefit via historical simulations in the third section. There are a number of variables that affect the results (tax rates, portfolio strategies, etc.). So I provide results across multiple scenarios. The fourth section discusses the relevance of the results and highlights practical examples where investors and related professionals can leverage these results to make better financial planning decisions.

Tax Benefits versus Tax Deferral

There is some confusion surrounding the tax benefits of retirement accounts. I suspect some of this is due to them being described as tax deferral benefits. I regularly hear investors and tax professionals use this description and you can find many instances of this around the internet and other media. Some highlight the benefit of reducing current income, and hence taxes, when making contributions to a retirement account. Some point out the likelihood of paying more taxes down the road when using retirement accounts (since the investments will appreciate and they will pay taxes on more income when it is taken out).