The Myth of Tax-free Compounding

Tax-free compounding increases the pre-withdrawal value of a tax-deductible account versus a tax-paid account. After all taxes are paid, assuming a constant tax rate, the results are more similar, although the tax-deductible account still produces a larger value. Tax-deductible accounts are perfect for anyone who will be in a lower tax bracket in retirement. That way, taxes are avoided since the deduction is made at a higher tax rate, and taxes are paid, upon withdrawal, at a lower rate. On the other hand, if the government increases tax rates over time, this expected benefit may be lost or reversed. Even if your tax rate stays the same, different types of income are taxed differently. If capital gains and dividends are taxed at a lower rate than withdrawals from the tax-deductible account, it’s possible that the final value of a tax-paid account would be higher. Finally, taking all of this into account, a tax-paid investment account that allows tax-free growth and withdrawals might be most beneficial of all.