The Myth of Tax-free Compounding

A commonly-held misconception is the idea that tax-free compounding will drastically increase the worth of your investment account. Let’s look at a couple examples to see why.

Let’s suppose that you have an account that allows you a tax deduction for contributions. How will that benefit you? Suppose you contribute $10,000 and receive a $3,000 refund (assuming 30% tax). You now have $13,000 to work with. If you invest both amounts and, over time, they double, your investment account is now worth $26,000. Contrast this to the alternative: paying $3,000 in taxes and investing only $10,000. If you invest that amount, in the same way and over the same period of time as above, let’s suppose it doubles to $20,000. This is the case that some people make for tax-free compounding: you have $26,000 in the tax-deductible account versus $20,000 in the tax-paid account.

The problem is that the money in the tax-deductible account isn’t available to spend, without withdrawing it. When it is withdrawn, taxes must be paid. Continuing with our example above, let’s compare three scenarios. Suppose your tax rate is unchanged at the time of withdrawal at 30%. From the tax-paid account, you must pay taxes on the growth of $10,000, leaving $17,000 you could spend. From the tax-deductible account, you must withdraw the balance, and pay the tax. If your tax rate is 30%, you will owe taxes of $7,800 and be left with $18,200 to spend. After tax, the result is only slightly better in the tax-deductible account.

Tax-deductible accounts are perfect for anyone who will be in a lower tax bracket in retirement. Generally, this is expected to be the case. Without a mortgage to repay and with income spread more evenly between two spouses, many people can expect to remain at lower tax rates after they stop working. A tax deduction is obtained, let’s suppose 30% as above. $13,000 doubles to $26,000. Then, in retirement, the marginal tax rate is 25%. Taxes are $6,500, leaving $19,500 to spend.

If your tax rate increased over time, you would be worse off with the tax-deductible account. In our example, you would receive your refund at 30% and pay taxes at a higher amount, let’s say 40%. In numbers: you deposit $10,000, receive a refund of $3,000, double it to $26,000, then pay $10,400 in taxes leaving $15,600. That is slightly worse than the tax-paid option: $10,000 doubles to $20,000, then 40% tax is owing on only the growth, leaving $16,000. Some people who may find themselves in this situation include chronic savers, government employees and anyone else with a generous pension over a large number of years. It could also happen if tax rates increase over time. In the 1990s, tax rates were generally higher than they are today. Governments have been reducing taxes (for certain groups), but there is no reason that trend couldn’t reverse. With deficits increasing and demographics threatening to reduce the proportion of workers to retirees, our tax rates could conceivably increase over our lifetime.

Even if your tax rate stays the same, different types of income are taxed differently. The tax rates for interest, dividends and capital gains have changed over time. You’ll need to do the math to see how it works currently, where you live. As a simple example, suppose in the example above, all of the growth came from capital gains and dividends. $10,000 is invested and doubles. When $20,000 is withdrawn, only $10,000 (the gain) is taxable at the lower capital gains or dividend rate. Instead of $3,000, the tax bill is only $1,500 for a net amount of $18,500. This is greater than the $18,200 net amount available from the $26,000 that had accumulated in the tax-deductible account.

It is not a foregone conclusion that the tax-free compounding of a tax-deductible account is an advantage. For most people who will be able to split income or otherwise be at a lower tax rate in retirement, a tax-deductible account will result in greater after-tax spendable income. For anyone who is in a higher tax rate in the future, most of whom will probably be surprised by a change in government policy, the tax-deductible account will not benefit them. At the same time, it will probably not be a large liability. Finally, for those who have the same tax rate in retirement as during their saving years, the usefulness of a tax-deductible account depends on the tax rates for dividends and capital gains, versus interest or withdrawals from the tax-deductible account. Taking all of this into consideration, a tax-paid investment account that allows tax-free growth and withdrawals (Roth IRA, TFSA) might be most beneficial of all.