I believe tax drag is real. I believe tax drag can cause losses in client portfolios. Thus, I believe advisors need to build plans that help mitigate tax drag. But I also believe the conventional wisdom solution is, shall we say, incomplete.
First, let’s define tax drag. Tax drag is the reduction of a portfolio’s annualized return due to the tax liability triggered by distributions and capital gains in a non-qualified account.
The textbook solution to tax drag tends to be using tax “shelters” like 401(k)s and IRAs. Tax-deferred vehicles prevent taxation on those funds come April 15 each year. And yes - you can be a more active trader of securities within a tax-deferred account, knowing there will be no short-term tax consequences for those trades.
But we all know that tax deferral in an IRA or 401(k) doesn’t happen forever. So, there’s a question we need to explore:
Does tax deferral in itself create its own form of tax drag?
If so, the traditional approach to addressing tax drag may actually create more tax drag in the long term.
With that in mind, let’s do some math. I’m going to look at taxable accounts, tax-deferred accounts, and tax-free accounts and then look at the impact of taxes on each.
Analyzing Tax Drag & Retirement Assets
For most savers, the idea of saving for the future is all about retirement - that stress-free part of life where savers can sit back and relax. Of course, for many, it’s not so stress-free. It’s about making sure they’ve saved enough - and saved it in the right way - to live that happy retirement.
This means that the real metric for savings, especially retirement savings, is the amount of spendable (i.e., after-tax) income a saver can generate.
Through this lens, we’re ready to evaluate tax drag.
Step 1:
First, let’s establish some assumptions for asset growth. Truthfully, when it comes to this exercise in tax drag, growth assumptions are less important than tax assumptions. So, we’ll pick something realistic and reasonable, and we’ll keep them consistent throughout the example (which is why they aren’t as important in this exercise as they are in real life).
Here’s what I’ll model: Equities at 8%, fixed income at 4%, and an advisory fee of 1.5%. And we’ll assume a 60/40 allocation mix. And we’ll assume the client’s tax bracket would dictate an effective rate of 20%, including state and federal taxes.
I just turned 50, so let’s make this example based on my age. And I’ll assume a retirement age of 65 and that I’ll live a long, healthy life to age 95.
Step 2:
Now, I’m ready to look at the after-tax income you can generate from a taxable account, a tax-deferred account, and a tax-free account. I’m going to apply the same assumptions from Step 1 to all three accounts.
Taxable
First off, let’s look at a taxable account. This account uses after-tax income, and then the growth in the account is also taxed as it is assumed. Since this is a tax-drag example, which applies mostly to actively traded accounts, the gains are assumed at the end of each year. That means taxes are being paid each year on the growth. These accounts do get favorable tax treatment in the form of a capital gains rate. So, we’ll apply a 15% capital gains rate instead of using ordinary income rates. (One of the few benefits of keeping assets in a taxable account).
Based on these assumptions, my current $400,000 account would grow to $714,000 by my retirement age, generating $39,843 of annual after-tax income, resulting in a total lifetime income of $1,170,000.
(It only took me 30 seconds to come up with those numbers. No, I’m not a wizard at mental math. I used Stonewood Financial’s tax-analysis software. You can check it out here or request your own sample here.)
Tax-Deferred
Now, let’s look at what an after-tax equivalent of tax-deferred money would generate under similar assumptions. To evaluate this, I’ll have to change two things from the previous example. First, the starting amount would be $500,000 instead of $400,000. That’s an extra $100,000 of pre-tax money to account for years and years of the annual write-off for the tax-deferred contributions (one of the benefits of a tax-deferred account). Don’t worry, IRS, we know those taxes are coming soon enough. Second, I need to change the tax assumption from 15% (capital gains rate) to the ordinary income rate, which, in this assumption, is an all-in effective tax rate of 20%.
Based on these assumptions, my current $500,000 tax-deferred account would grow to $1,024,713 by my retirement age, generating $50,258 of annual after-tax income, resulting in a total lifetime income of $1,500,000.
Did you catch that?
The difference between the total lifetime income in a taxable and tax-deferred account is nearly $330,000! This is one way to calculate the cost of tax-drag.
But that’s not the end of the evaluation.
You see, there is another form of retirement account, one that allows you to access income from your retirement accounts in a tax-free manner. That type of account is called a Roth IRA.
Tax-Free
Roth account contributions are made with after-tax dollars (similar to a taxable account), but the growth in the account is tax-free.
So, let’s adjust these assumptions for a Roth. The beginning balance would be $400,000 (because we are not getting the benefit of that annual tax write-off). And the tax rate during distribution is… zero (an obvious benefit to the Roth).
Based on these assumptions, my current $400,000 Roth account would grow to $819,771 by my retirement age, generating $50,258 of annual tax-free income, resulting in a total lifetime income of $1,500,000.
A HUGE difference in income.
Right?
Well, actually, NO.
In fact, the after-tax income is exactly the same for the Tax-Deferred Account and the Tax-Free Account. Did I make a mistake?
I didn’t make a mistake, and the numbers don’t lie. If your growth assumptions and your tax assumptions are exactly the same, then the after-tax income amounts in a tax-deferred and tax-free account will also be the same. The calculation may look a little different, but in the end, you get to the exact same place.
You see, I made a fundamental flaw in my assumptions. I just casually assumed a 20% tax rate throughout. I assumed my taxes would stay the same.
How likely do you think that is?
And if it’s unlikely (which I think we can all agree), what happens if my taxes are higher in the future than planned?
Myself and many, many experts believe we are headed into a period of higher taxes on U.S. savers based on our country’s demographics, debt, and spending. At a minimum, we know the Trump Tax Cuts are expiring in 2025, meaning individual income tax bracket rates are reverting to their older, higher rates.
Thus, the flaw in my assumptions.
So, let’s fix that. I’ll now assume that my effective tax rate will go from 20% to 23% in 2025 when the Trump Tax Cuts expire. And then let’s assume another tax increase in 10 years. (Surprisingly, that only gets us back to where taxes were just two short decades ago… but that’s a blog topic for another day.)
If my taxes rise, here’s what the numbers show:
My $500,000 tax-deferred account would still grow to $1,024,713 by my retirement age, but those tax increases would cut into the after-tax income amount. I would now generate $46,489 of after-tax income, resulting in a total lifetime income of $1,390,000.
Now, we have to apply these tax changes to the Roth.
Or do we? You see, the income from the Roth is immune to tax increases.
Evaluating True Tax Drag
So, with proper assumptions, your three options would be summarized as follows:
Taxable – Total Income $1,170,000
Tax-Deferred – $1,390,000
Roth - $1,500,000
I want to post one final question when it comes to tax drag:
The tax-deferred projections are delivering $110,000 less than the tax-free projections.
What would you call that loss? It’s definitely a drag on the portfolio. And why? Because tax policy changed.
To me, that’s another form of tax drag - and an important one many of us aren’t evaluating for our clients.
I believe this second form of tax drag is a risk worth mitigating for American savers. It’s the only way to evaluate the complete risks taxes could have on your client’s income in retirement. Be the advisor in your market who can articulate this risk. Recognize the true threat tax risk poses to your client’s portfolios. And, of course, build plans to help mitigate that risk.
Note: This was a fun exercise quantifying tax drag in a new way. Of course, we know this exercise is an oversimplification. Tax rates in taxable accounts can be wildly different based on when gains are realized. There is great value in an advisor who understands these differences in managing tax-efficient strategies within taxable accounts. But the points made in this piece around tax-deferred and tax-free are also extremely important, and I hope you’ve learned valuable information from this exercise. If you would like to discuss this further, schedule a call with one of the members of my team here.