Financial Planning Workshop: Session 2

Welcome to the second of five sessions in our Financial Planning Workshop. Today we will discuss another topic that should be considered when planning for your future. This workshop will not develop a comprehensive financial plan for you, but instead is intended to give you some ideas and tips to help in your planning.

To reiterate, financial planning is the process of organizing your financial attributes (assets, liabilities, earnings, expenses, taxes, savings, investments) to achieve the financial results you want in life (nice house, college savings, early retirement, vacation home).  The process takes a lot of thought and changes over time.

The Best Type of Investment Account

There are three main types of investment accounts that most of us can use to invest: a tax-deferred retirement account (401k, SEP, IRA), a taxable brokerage account, and a variable annuity. [For this discussion, I am excluding Roth IRA accounts because their use is limited by income level.]  Each of these types of accounts have their own benefits and limitations.

Retirement Accounts

Pros:  You get a tax deduction when you invest in a retirement account and tax deferred growth until you begin taking distributions.

Cons:  There are limits to the amount you can invest, until you are age 59 ½ you incur a penalty on any distributions, and distributions are taxed as ordinary income.

Taxable brokerage accounts

Pros:  There is no limit to how much you can invest, capital gains and dividends are taxed at rates less than ordinary income.

Cons:  You receive no tax deduction for contributions and taxes must be paid as income is realized. 

Variable annuities

Pros:  There is no limit to how much you can invest, gains are not taxed until you make a withdrawal, and there is an insurance component that returns your original investment (less withdrawals) if the account balance at death is less than your original investment.

Cons:  You receive no tax deduction for contributions, the management fees and insurance costs typically cost at least 1.5% more per year than either retirement accounts or taxable accounts, and gains are taxed as ordinary income when distributed.

Given all the pros and cons, which type of account generates the largest after-tax returns? Let’s assume the following:

  • All accounts earn 7% per year (the additional 1.5% fee for the variable annuity will reduce its return).
  • Contributions of $10,000 per year will be made to each account. The tax savings from the retirement accounwill accumulate in a “side” taxable account and be added to the retirement balance.
  • Ordinary income is taxed at 39.6% and capital gains and dividends are taxed at 23.8% (The highest current tax rates).
  • The amounts in the table below are net of all taxes.

As you can see, the retirement account accumulates the largest after-tax balance for all time periods with the taxable account in second place.  Why is this so? The lower tax rates of the taxable account cannot overcome the tax savings on the contributions to the retirement account. The annuity cannot overcome its high fees.

Always fully fund your retirement accounts before investing in a taxable brokerage account.  If you are tempted to invest in an annuity, seek an unbiased opinion first.  Then invest in something else!