Taxable vs tax-deferred investment accounts refer to the different tax treatments for investment income and gains.
Taxable accounts are investment accounts where you pay taxes on any income and capital gains as you earn or sell investments. For example, a traditional brokerage account is a taxable account. In these accounts, any dividends, interest, or capital gains are taxed in the year they are received.
Tax-deferred investment accounts, on the other hand, are accounts where you can defer paying taxes on the income and gains until you withdraw the money. Examples of tax-deferred investment accounts include traditional individual retirement accounts (IRAs) and employer-sponsored retirement plans such as 401(k)s.
Let's consider two scenarios, in both scenarios an investor invests $10,000 in a taxable account and $10,000 in a tax-deferred account.
In the taxable account, the investor earns an average annual return of 7% and pays taxes on their investment gains at a rate of 20% each year. After 30 years, the investment would be worth approximately $97,243.
In the tax-deferred account, the investment grows at the same average rate of 7% annually but taxes are deferred until the investor withdraws the funds. After 30 years, the investment would be worth approximately $143,416.
At the end of the 30-year period, if the investor were to withdraw all funds from the tax-deferred account, they would have to pay taxes on their gains at the current tax rate. In this example, if the current tax rate is still 20%, the investor would pay $28,683 in taxes and be left with a total of $114,733.
This comparison demonstrates the advantage of tax-deferred investment accounts over taxable accounts, as the tax-deferred account provides the investor with a larger overall account value due to the deferral of taxes. However, it's important to keep in mind that taxes will eventually have to be paid and that the investor should consider their expected tax rate at the time of withdrawal when determining the best investment strategy.
