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Taxes are one of the largest factors affecting investors’ returns. Because of taxes, it makes sense...

Taxes are one of the largest factors affecting investors’ returns. Because of taxes, it makes sense to fund your retirement through so-called tax advantaged accounts (IRAs, 401(k)s, and the like). Suppose, you have access to one of these accounts.

  1. Compare a $5,000 a year investment in a tax-free account versus a similar annualinvestment in a regular taxable account over the next 25 years.
  2. Assume the rate of return of 10% per year on both accounts and a tax rate of 20% on long term capital gains (all of the taxes are deferred until retirement). Calculate the difference in the accounts' values after 25 years.
  3. Discuss the implications for your own retirement savings.
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Answer #1

The 5000 investment every year for 25 years would result in =FV(rate,nper,pmt) in excel =FV(0.10,25,5000) = 491,735.30

In a tax free account there are no taxes.

So, the amount after 25 years will be = $491,735.30

In a taxable account, capital gains are taxes at 20%. So Net investment = 5000*25 = 125,000

So Capital gains = 491,735.30 -125,000 = 366,735.30

Taxes = 0.20*366,735.30 = 73,347.06

After tax value =  491,735.30 - 73,347.06 = $418,338.24

So, the amount after 25 years will be = $418,338.24

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