Quantifying the Tax Benefit of Retirement Accounts for Better Client Decisions (Part 1)
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How should clients use tax-advantaged accounts? By quantifying the tax benefits of those accounts, we can refine recommendations on asset location and the traditional-versus-Roth decision. Specifically, low-return assets, even if otherwise taxed at high rates, may not benefit much from being placed in tax-advantaged accounts. Also, the choice between traditional and Roth contributions is asymmetric: Traditional accounts provide an opportunity for a higher tax benefit, but risk incurring a tax cost. Roth contributions provide greater certainty of a positive tax benefit.
The value of tax benefits
The basic structure of tax-advantaged accounts can be summarized as follows:
The table highlights that avoiding tax on investment income (including capital gains) is a key source of the tax benefit.
What is the value of this benefit? I compare the tax-advantaged account accumulation with a (counterfactual) taxable account accumulation. This is the trade-off faced by clients who must decide whether to contribute to a tax-advantaged account, what type of account to choose, and which investments to place in the account.
Per dollar, the prospective value of the tax benefit is given by: