During 2015, the average American will be allowed to contribute up to $5,500 to their Roth IRA and up to $18,000 to their 401(k)/403(b). These two investment vehicles can generate fabulous returns for American investors when consistently funded and managed responsibly, and have the potential to blow away any returns that one can manage in a traditional taxable brokerage account. The potential for a Roth IRA or 401(k)/403(b) is so great that, arguably, very few Americans should be funding a private taxable brokerage account at all.
According to TaxFoundation.org, US wage earners will face a 31.5% tax burden on their pre-tax income for 2015. This means that the US government will confiscate $31.50 out of the typical American’s paycheck in the form of individual income and payroll taxes for each $100 they earn from their employer. That is a massive amount of lost wealth for the individual. Given that massive wealth loss, a retirement account that avoids the effect of taxes, when compounded over decades, will have a staggeringly huge advantage over an account subject to taxation. Luckily, these tax-sheltered retirement accounts exist for the masses.
The Roth IRA
The Roth Individual Retirement Account is perhaps the greatest investment account ever made available to the general public. This account provides the holder with tax-free income in retirement. Although there is no up-front tax deduction for Roth IRA contributions, the future distributions are completely tax-free when the rules are followed. Contributions are made with taxed income – you cannot use pre-tax income to fund a Roth IRA – but at Age 59 1/2, you may withdrawal money from the account with no tax penalty. Individuals making $116,000 or less may contribute up to $5,500 to a Roth IRA in 2015. The income phase-out range is $116,000 to $131,000. Above $131,000, you are not eligible for a contribution. Limits are different for married couples filing jointly.
The 401(k)/403(b) are retirement accounts provided through most employers. Unlike a Roth IRA, the 401(k)/403(b) allows for the employee to make contributions with pre-tax income. Contributions to a 401(k)/403(b) are tax deductible. This means a person making $55,000 in income per annum that contributes $5,000 to their 401(k)/403(b) only has to pay taxes on $50,000 of their income come April 15th. Come Age 59 1/2, the account holder may make withdrawals with no early distribution penalty. The withdrawals will be subject to income tax. However, the investment is allowed to grow tax-deferred in that account for the duration and is not subject to the taxes on any capital gains paid like a private taxable brokerage account is.
In 2015, the typical American will be able to make a combined $23,500 in contributions to their Roth IRA and 401(k)/403(b) plans ($5,500 and $18,000 respectively). Let us consider two candidates: John and Jane.
Both John and Jane have a Roth IRA and make the maximum contribution of $5,500. Both can afford to invest another $5,000 of their pre-tax income each year for the next 30 years. John decides to place that money into a private brokerage account from a popular discount online broker. He invests 100% of the money in a low-cost mutual fund that mirrors the S&P 500. Jane decides to place that money into her 401(k), which is also set to invest 100% into a low-cost fund that mirrors the S&P 500 index. Both hold their money for a full investment lifetime – 30 years.
Jane’s $5,000 investment compounds at 10%, which is the average annual return of the S&P 500 since its inception in 1928. Her investment grew to $904,717.12.
John had to pay a tax rate of 31.5% on his $5,000 contribution. Because of that, he was only able to invest $3,425 per annum. His investment grew to $619,731.23.
Simply because Jane used pre-tax income instead of taxed income, she outperformed John by 46%. And remember, this assumes there were no dividend distributions along the way. Truthfully, S&P 500 mirroring funds typically pay a significant dividend. Reinvesting that dividend would make Jane’s performance even more exceptional since John would be paying capital gains taxes on that distribution every year. Factor in state and local taxes and the avalanche effect continues to compound.
There are drawbacks to a 401(k)/403(b). While a private brokerage account will allow the individual investor the option to invest in any stock, bond, mutual fund, ETF, option contract, commodity contract or any of the other virtual infinity of investment vehicles available in the open market, a 401(k)/403(b) is bound to a handful of mutual funds chosen by the employer. However, this illustrates that a taxable brokerage account must outperform a 401(k)/403(b) by at least 45.99% to see the same returns over an investment lifetime. The historic 30-year average return of the S&P 500 is 10% per annum, so a private taxable account must compound at more than 14.6% per annum to be competitive. And remember, in reality, the gains in a taxable account are also subject to capital gains taxes on any distributions that occur throughout the year, and of any gains made on the sale of an equity. The account holder cannot claim an income deduction for contributions like a person can for a 401(k)/403(b) contribution, either.
Taxable brokerage accounts certainly have their place, but unless the account holder is extremely confident in their ability to hand-pick equities or well beyond the income thresholds that allow them to contribute to these accounts, they often do not make sense until a person has exceeded $23,500 in investments in tax-sheltered accounts for the year (2015 dollars), a figure that most Americans will not come close to achieving. According to the SPIVA Year-End 2014 US Scorecard, 86.44% of large-cap fund managers underperformed the S&P 500. This figure is just as dismal over 5- and 10-year periods, at 88.65% and 82.07% underperformance respectively. Do you think you are a better stock-picker than a full-time professional fund manager?All information found herein, including any ideas, opinions, views, predictions, commentaries, forecasts, suggestions or stock picks, expressed or implied, are for informational, entertainment or educational purposes only and should not be construed as personal investment advice. I am not a licensed investment adviser.