A recent article by Kathy Kristof of Kiplinger’s made me rethink some common financial advice that many people just take for granted. In Why I Pay Taxes Now, Kristof argues that investing through a tax-deferred account such as a 401(k) is not necessarily more advantageous than investing in a taxable account.
Many of you will have a hard time believing that since you have no doubt seen studies that clearly demonstrate the power of compounding gains over time in a tax deferred account. By paying taxes later you get to invest more now and your money grows much faster.
Note – Kristof does advocate investing in a 401(k) with an employer match or a Roth IRA which allows tax-free withdrawals in retirement.
But it’s not the mathematics that Kristof disputes, it’s the assumptions behind the math. Remember, we’re not logical machines. Sometimes our emotions cause us to make decisions that are not in line with those suggested by an equation or computer simulation.
For example, conventional wisdom would say that if you earned $10,000 this year on a $100,000 account balance and paid $1,500 in taxes you’d only have $108,500 left to reinvest. But if you had invested through a tax-deferred account you would have $110,000.
Obviously, we’d all rather have $110,000 than $108,500. But behind the numbers is an assumption that taxes paid on investments come out of your account. But what if you pay them elsewhere? What if you pay it out of your salary through increased withholding? Or what if you take a bit from your savings account or your yearly bonus check?
In that case your account balance will still be $110,000 and you would have already paid taxes on the gain, so you actually come out ahead in retirement.
Of course, you’d have to live without that $1,500 in the here and now which might mean living with a slightly smaller TV or a more practical car for awhile. But this example just goes to show you that you can’t just assume that financial rules of thumb will work for all people and in all situations. They don’t call it personal finance for nothing.