Tax Benefit of a Retirement Account

Measuring the advantage

Sometimes the reaction to one of my articles makes me realize there's a need for another one. That was the case when I wrote about the Roth conversion benefit no one understands. The purpose of that article was to show that even when a Roth conversion is taxed at today's highest rate of 35%, the result of the conversion can be a 54% increase in the tax benefit produced by the retirement account. Some people misunderstood the article, though, leading me to realize I should have begun by explaining what I mean when I refer to the tax benefit produced by a retirement account.

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The choice

Within limits you have a choice as to where you invest your money. The default is a regular investment account. There is no dollar limit on the amount you can save and invest in such an account. Investment earnings produced by the account are subject to income tax, however. Each year you have to report on your income tax return the amount of interest, dividends, capital gains and other investment income produced by the account — even if you choose to leave those earnings in the account. We refer to this type of account as a taxable account.

Congress has created a number of special types of accounts to help people save for retirement, college expenses, or other purposes. Our focus here is on retirement accounts, and we want to begin with the Roth IRA. This type of account makes it possible (if you satisfy certain requirements) to eliminate tax on investment earnings. When you don't have to pay tax on the investment earnings, the account can grow faster. How much faster depends on the types of returns produced by the taxable account and the tax rates that apply to those returns.

For the sake of discussion, let's say your investments will grow at a rate of 7% in a Roth IRA, but will grow at a rate of 6% in a taxable account because income tax will claim a portion of each year's investment earnings. If the Roth and the traditional account begin with the same amount of money, the Roth will gradually pull ahead. Initially the difference will be small, but after many years the magic of compound interest will cause the accounts to diverge substantially.

Tax benefit provided by the account

When I refer to the tax benefit provided by a retirement account, I am referring to the number in the last column of the table below. Based on the assumptions we've made about the rates at which taxable and tax-free accounts grow, the Roth account produces a tax benefit of $17,630 after 10 years and $186,876 after 30 years. 

What would happen if someone had $100,000 equally divided between a taxable account and a Roth account? The result after any given period of time would be exactly halfway between the result where all the money is in a taxable account and the result where all the money is in a Roth. Someone who has $50,000 in a taxable account and $50,000 in a Roth is getting only half as much tax benefit from his retirement account as someone who has $100,000 in a Roth.

Let's be clear about this. I'm not saying that someone with $100,000 in a Roth will eventually retire with twice as much money as someone with $50,000 in a taxable account and $50,000 in a Roth. I'm simply saying that the tax benefit provided by the Roth relative to investing in a taxable account, whatever that benefit might be, will end up being twice as large if you have twice as much money in the Roth.

	Taxable Account	Roth Account	Difference
Initial balance	$100,000	$100,000	$0
After 10 years	179,085	196,715	17,630
After 20 years	320,714	386,968	66,255
After 30 years	574,349	761,226	186,876

 

With this background, we can turn to the question of how a Roth conversion can increase the tax benefit provided by a retirement account.

details: The Roth Conversion Benefit No One Understands

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