October 2020 – Page 2

How to Calculate the Tax-Drag of Wealth Based Taxation

In the United States, there has been talk of implementing a wealth tax in order to generate revenue off of wealthier individuals. While the politics of a wealth tax are beyond the scope of this post, we can still examine the effects of wealth based taxation on a quantitative basis.

The future value interest factor formula that accounts for an annual tax on wealth is as follows:

FVIF of wealth based taxation formula

Where:

Assume that an individuals portfolio which comprises their entire net worth will grow at a required rate of 7% for 10 years and the tax rate on wealth is 1% annually, plugging those values into the formula will yield the following:

wheres; r = 0.07, wealth tax = 1%, n = 10

An individual with an initial net worth of $1,000,000 would be worth $1,779,100 in ten years.

On the surface, a 1% tax on wealth doesn’t seem like much when this individual’s portfolio is now worth $1.7mm dollars; however, let’s quantify the tax-drag that wealth based taxation has on net worth.

Recall that the formula used to calculate tax-drag is as follows:

where:

In order to calculate the tax-drag we need to compute the value of the portfolio without taxes as follows:

where; r = 0.07, n = 10, PV = $1,000,000

We can now plug the ending values of the tax-free and taxable accounts into the tax-drag formula:

The tax-drag in this particular scenario is 19.44%. In other words, a 1% tax on wealth every ten years eroded 19.44% of the appreciation relative to the tax-free account.

Constructing a tax-drag table that quantifies the effect wealth based taxation has over time will illustrate how destructive wealth taxes are even if wealth taxes are in the low single digits per annum.

First let’s construct the future value table for the tax-free account:

	Rate
	2%	3%	4%	5%	6%	7%
Year	($ 000s)
1	$ 1,020.00	$ 1,030.00	$ 1,040.00	$ 1,050.00	$ 1,060.00	$ 1,070.00
2	$ 1,040.40	$ 1,060.90	$ 1,081.60	$ 1,102.50	$ 1,123.60	$ 1,144.90
3	$ 1,061.21	$ 1,092.73	$ 1,124.86	$ 1,157.63	$ 1,191.02	$ 1,225.04
4	$ 1,082.43	$ 1,125.51	$ 1,169.86	$ 1,215.51	$ 1,262.48	$ 1,310.80
5	$ 1,104.08	$ 1,159.27	$ 1,216.65	$ 1,276.28	$ 1,338.23	$ 1,402.55
6	$ 1,126.16	$ 1,194.05	$ 1,265.32	$ 1,340.10	$ 1,418.52	$ 1,500.73
7	$ 1,148.69	$ 1,229.87	$ 1,315.93	$ 1,407.10	$ 1,503.63	$ 1,605.78
8	$ 1,171.66	$ 1,266.77	$ 1,368.57	$ 1,477.46	$ 1,593.85	$ 1,718.19
9	$ 1,195.09	$ 1,304.77	$ 1,423.31	$ 1,551.33	$ 1,689.48	$ 1,838.46
10	$ 1,218.99	$ 1,343.92	$ 1,480.24	$ 1,628.89	$ 1,790.85	$ 1,967.15

future value of tax-free account table

We’ll do the same for the taxable account assuming an annual wealth tax of 1%:

	Rate
	2%	3%	4%	5%	6%	7%
Year	($ 000s)
1	$ 1,009.80	$ 1,019.70	$ 1,029.60	$ 1,039.50	$ 1,049.40	$ 1,059.30
2	$ 1,019.70	$ 1,039.79	$ 1,060.08	$ 1,080.56	$ 1,101.24	$ 1,122.12
3	$ 1,029.69	$ 1,060.27	$ 1,091.45	$ 1,123.24	$ 1,155.64	$ 1,188.66
4	$ 1,039.78	$ 1,081.16	$ 1,123.76	$ 1,167.61	$ 1,212.73	$ 1,259.15
5	$ 1,049.97	$ 1,102.46	$ 1,157.02	$ 1,213.73	$ 1,272.64	$ 1,333.81
6	$ 1,060.26	$ 1,124.18	$ 1,191.27	$ 1,261.67	$ 1,335.51	$ 1,412.91
7	$ 1,070.65	$ 1,146.32	$ 1,226.53	$ 1,311.51	$ 1,401.48	$ 1,496.69
8	$ 1,081.14	$ 1,168.91	$ 1,262.84	$ 1,363.31	$ 1,470.71	$ 1,585.45
9	$ 1,091.74	$ 1,191.93	$ 1,300.22	$ 1,417.17	$ 1,543.37	$ 1,679.46
10	$ 1,102.44	$ 1,215.41	$ 1,338.71	$ 1,473.14	$ 1,619.61	$ 1,779.06

future value of taxable account

Now we can calculate the tax-drag table using the two tables above:

	Rate
	2%	3%	4%	5%	6%	7%
Year
1	51.00%	34.33%	26.00%	21.00%	17.67%	15.29%
2	51.25%	34.67%	26.38%	21.40%	18.09%	15.72%
3	51.49%	35.00%	26.76%	21.81%	18.52%	16.17%
4	51.74%	35.34%	27.14%	22.22%	18.95%	16.62%
5	51.99%	35.67%	27.52%	22.64%	19.39%	17.08%
6	52.24%	36.01%	27.91%	23.06%	19.83%	17.54%
7	52.48%	36.35%	28.30%	23.48%	20.28%	18.01%
8	52.73%	36.69%	28.69%	23.91%	20.73%	18.48%
9	52.98%	37.02%	29.08%	24.33%	21.19%	18.96%
10	53.22%	37.36%	29.47%	24.77%	21.65%	19.45%

tax-drag table

Notice how the tax-drag is much higher if your net worth grows at a lower assumed rate of return. Higher rates can somewhat offset the tax-drag; however, a 2% rate of return over ten years has a tax-drag of over 53.22%, and that’s if the annual wealth tax is “only” 1%. Imagine having a tax-drag of 53.22% over ten years before adjusting for inflation. Can you say, “Capital flight”?

The Excel model used to calculate the tax-drag of annual wealth taxes can be found here.

How to Calculate the Tax-Drag on a Taxable Account

In order to calculate the tax-drag on a taxable account, you need to compare the net after-tax future value of a taxable account to the future value of a tax-free account. These values are then plugged into the following formula:

Where:

We can define the ending value of a tax-free account as follows:

ending value of a tax-free account formula

The formula above is essentially the future value formula with a different set of variables. Recall, that the future value of a taxable account adjusts the rate of return by a quantity that takes into account annual accrual based taxation:

ending value of a taxable account formula

Assume you made a $1,000 investment into a security that was projected to pay a 4% dividend for ten years, with an annual dividend tax of 30%. What is the tax-drag on the taxable account relative to the tax-free account?

In order to calculate the tax-drag we need to plug the variables into both future value formulas:

where; V-naught = $1,000, r = 0.04, n = 10

Plugging those same values to solve for the ending value of the taxable account yields the following:

where; V-naught = $1,000, r = 0.04, t = 30%, n = 10

Now that we have calculated the ending values for both the tax-free and taxable accounts, we can plug those values into the tax-drag formula:

Notice that the tax-drag of 33.7% is higher than the annual tax rate of 30%. The additional tax erosion above and beyond the 30% annual rate of taxation is due to paying 30% every year in the taxable account, relative to not paying any taxes in the tax-free account.

We can illustrate the longer term detrimental effects of tax-drag by constructing a tax-drag table. Using Excel, let’s compute a future value table for a tax-free account, assuming an annual tax rate of 30%:

	Rate
	2%	3%	4%	5%	6%	7%
Year
1	$ 1,020.00	$ 1,030.00	$ 1,040.00	$ 1,050.00	$ 1,060.00	$ 1,070.00
2	$ 1,040.40	$ 1,060.90	$ 1,081.60	$ 1,102.50	$ 1,123.60	$ 1,144.90
3	$ 1,061.21	$ 1,092.73	$ 1,124.86	$ 1,157.63	$ 1,191.02	$ 1,225.04
4	$ 1,082.43	$ 1,125.51	$ 1,169.86	$ 1,215.51	$ 1,262.48	$ 1,310.80
5	$ 1,104.08	$ 1,159.27	$ 1,216.65	$ 1,276.28	$ 1,338.23	$ 1,402.55
6	$ 1,126.16	$ 1,194.05	$ 1,265.32	$ 1,340.10	$ 1,418.52	$ 1,500.73
7	$ 1,148.69	$ 1,229.87	$ 1,315.93	$ 1,407.10	$ 1,503.63	$ 1,605.78
8	$ 1,171.66	$ 1,266.77	$ 1,368.57	$ 1,477.46	$ 1,593.85	$ 1,718.19
9	$ 1,195.09	$ 1,304.77	$ 1,423.31	$ 1,551.33	$ 1,689.48	$ 1,838.46
10	$ 1,218.99	$ 1,343.92	$ 1,480.24	$ 1,628.89	$ 1,790.85	$ 1,967.15

future value of a tax-free account table

Let’s do the same for a taxable account:

	Rate
	2%	3%	4%	5%	6%	7%
Year
1	$ 1,014.00	$ 1,021.00	$ 1,028.00	$ 1,035.00	$ 1,042.00	$ 1,049.00
2	$ 1,028.20	$ 1,042.44	$ 1,056.78	$ 1,071.23	$ 1,085.76	$ 1,100.40
3	$ 1,042.59	$ 1,064.33	$ 1,086.37	$ 1,108.72	$ 1,131.37	$ 1,154.32
4	$ 1,057.19	$ 1,086.68	$ 1,116.79	$ 1,147.52	$ 1,178.88	$ 1,210.88
5	$ 1,071.99	$ 1,109.50	$ 1,148.06	$ 1,187.69	$ 1,228.40	$ 1,270.22
6	$ 1,087.00	$ 1,132.80	$ 1,180.21	$ 1,229.26	$ 1,279.99	$ 1,332.46
7	$ 1,102.21	$ 1,156.59	$ 1,213.25	$ 1,272.28	$ 1,333.75	$ 1,397.75
8	$ 1,117.64	$ 1,180.88	$ 1,247.23	$ 1,316.81	$ 1,389.77	$ 1,466.24
9	$ 1,133.29	$ 1,205.68	$ 1,282.15	$ 1,362.90	$ 1,448.14	$ 1,538.08
10	$ 1,149.16	$ 1,231.00	$ 1,318.05	$ 1,410.60	$ 1,508.96	$ 1,613.45

future value of a taxable account table

With these two tables, we can now compute a tax-drag table using the values above:

	Rate
	2%	3%	4%	5%	6%	7%
Year
1	30.00%	30.00%	30.00%	30.00%	30.00%	30.00%
2	30.21%	30.31%	30.41%	30.51%	30.61%	30.71%
3	30.42%	30.62%	30.83%	31.03%	31.23%	31.43%
4	30.63%	30.93%	31.24%	31.55%	31.85%	32.15%
5	30.83%	31.25%	31.66%	32.07%	32.47%	32.87%
6	31.04%	31.56%	32.08%	32.59%	33.10%	33.61%
7	31.26%	31.88%	32.50%	33.12%	33.73%	34.34%
8	31.47%	32.20%	32.92%	33.65%	34.37%	35.08%
9	31.68%	32.51%	33.35%	34.18%	35.00%	35.82%
10	31.89%	32.83%	33.77%	34.71%	35.64%	36.57%

30% tax-drag table

As you can see, the importance of sheltering gains from taxation (in a legal manner of course) becomes extremely important the longer the time frame, the higher the tax rate, and the higher the expected level of return. Based on the table above, the tax-drag on an investment with a 7% rate of return over 10 years is 36.57%, which is much higher than 30%.

Understanding the impact of tax-drag illustrates the importance of having a tax-diversification strategy in addition to an asset diversification strategy. For instance, hold longer term capital appreciating securities which pay no dividends or interest in a taxable account, while investing in interest bearing and dividend paying securities inside of tax-sheltered accounts such as Traditional IRAs and Roth IRAs or employer sponsored retirement plans.

Generally speaking, if taxes are paid on an annual basis the tax-drag will be greater than the tax rate. Conversely, if taxes are deferred until the end of the period the tax-drag will be equal to the tax rate.

A copy of the Excel model used to construct the tax-drag table can be found here.

How to Calculate Accrual Based Taxes on Interest and Dividends

Calculating the future value of an account that taxes interest and dividends on an annual basis requires a basic understanding of future value interest factors (FVIFs).

The formula utilized to calculate the FVIF which takes into account this method of taxation is as follows:

FVIF accrual based dividends formula

The annual taxation on dividends is reflected in the formula above by adjusting the rate of return by the quantity (1 – tax on dividends). The formula for accrual based taxes on interest is identical:

FVIF accrual based interest taxes formula

The only difference between the two formulas is the use of subscript “d” versus subscript “i”.

Let’s assume that an investment paid an annualized rate of interest of 4% for ten years, and the annual tax on interest was 15%. Plugging those values into the formula above would yield the following:

where; r = 0.04, t-interest = 15%, n = 10

If your initial investment was $1,000, you could calculate the future value in the tenth year by multiplying $1,000 by the FVIF of 1.3970:

future value

Using Excel we can construct a FVIF table that takes into account different rates of taxation on interest or dividends, the FVIF table below is constructed with a discount rate of 4%:

	t-interest
year	10%	15%	20%	25%	30%
1	1.03600	1.03400	1.03200	1.03000	1.02800
2	1.07330	1.06916	1.06502	1.06090	1.05678
3	1.11193	1.10551	1.09910	1.09273	1.08637
4	1.15196	1.14309	1.13428	1.12551	1.11679
5	1.19344	1.18196	1.17057	1.15927	1.14806
6	1.23640	1.22215	1.20803	1.19405	1.18021
7	1.28091	1.26370	1.24669	1.22987	1.21325
8	1.32702	1.30667	1.28658	1.26677	1.24723
9	1.37479	1.35109	1.32775	1.30477	1.28215
10	1.42429	1.39703	1.37024	1.34392	1.31805

FVIF accrual based taxes on interest table, where; r = 0.04

Obviously, the higher the rate of taxation the more it will reduce the FVIF.

The Excel model for FVIFs based on annual accrual taxation can be found here.

How to Calculate Future Value and Present Value Interest Factors

The concept of future value and present value interest factors is an important one to understand when you begin to calculate future and present values which take into account more complex forms of taxation.

For instance, to determine the future value of an account that taxes interest or dividends on an annual basis at some specified rate would require you to calculate the future value interest factor using a formula that solves for such method of taxation.

Before the age of calculators and computers, solving future value and present value equations required the use of interest factor tables. Fortunately, solving for the factors is easier than in sounds.

The future value interest factor (FVIF) is simply the quantity that the present value is compounded by:

future value interest factor formula

Let’s construct a future value interest factor table using an assumed annual rate of 7%:

	Rate
	2.00%	3.00%	4.00%	5.00%	6.00%	7.00%
Year
1	1.0200	1.0300	1.0400	1.0500	1.0600	1.0700
2	1.0404	1.0609	1.0816	1.1025	1.1236	1.1449
3	1.0612	1.0927	1.1249	1.1576	1.1910	1.2250
4	1.0824	1.1255	1.1699	1.2155	1.2625	1.3108
5	1.1041	1.1593	1.2167	1.2763	1.3382	1.4026
6	1.1262	1.1941	1.2653	1.3401	1.4185	1.5007
7	1.1487	1.2299	1.3159	1.4071	1.5036	1.6058
8	1.1717	1.2668	1.3686	1.4775	1.5938	1.7182
9	1.1951	1.3048	1.4233	1.5513	1.6895	1.8385
10	1.2190	1.3439	1.4802	1.6289	1.7908	1.9672

future value interest factor table

Let’s assume you wanted to calculate the future value interest factor for an investment that will grow at 7% for ten years, plugging those values into the future value interest factor equation will yield the following:

where; r = 0.07, n = 10

Using the table above and finding the area where n = 10 and r = 7% intersect indicates that the FVIF is 1.9672. Any dollar amount multiplied by the FVIF of 1.9672 will yield the future value of an investment that grew at 7% for ten years.

Present value interest factors (PVIF) are simply the inverse of FVIFs:

We can construct a PVIF table in the same manner:

	Rate
	2%	3%	4%	5%	6%	7%
Year
1	0.9804	0.9709	0.9615	0.9524	0.9434	0.9346
2	0.9612	0.9426	0.9246	0.9070	0.8900	0.8734
3	0.9423	0.9151	0.8890	0.8638	0.8396	0.8163
4	0.9238	0.8885	0.8548	0.8227	0.7921	0.7629
5	0.9057	0.8626	0.8219	0.7835	0.7473	0.7130
6	0.8880	0.8375	0.7903	0.7462	0.7050	0.6663
7	0.8706	0.8131	0.7599	0.7107	0.6651	0.6227
8	0.8535	0.7894	0.7307	0.6768	0.6274	0.5820
9	0.8368	0.7664	0.7026	0.6446	0.5919	0.5439
10	0.8203	0.7441	0.6756	0.6139	0.5584	0.5083

present value interest factor table

Notice, if you multiply any FVIF by its corresponding PVIF the product of the two numbers will equal one:

FVIF * PVIF

Using an HP12C calculator, we can solve for the FVIF in the example above using the following keystrokes:

[1][.][0][7][ENTER]
[10][y^x]

The Excel model for FVIF and PVIF table construction can be found here.

How to Calculate the Future Value of a Tax-Deferred Account

Recall, that the formula utilized to calculate the future value of a lump sum is as follows:

future value formula

Where:
FV = Future Value
PV = Present Value
r = rate
n = periods

Calculating the future value of a tax-deferred account incorporates the tax paid on the money when it is withdrawn during the final period. We can account for the taxes paid by adjusting the present value after it has been compounded by the specified rate and number of periods:

future value of a tax-deferred account

The addition of the quantity (1 – t) adjusts the future value in the final period by the tax that is owed.

Assume you have a present value of $1,000, the will grow at a rate of 7% for ten years, with an assumed tax rate of 30%. Plugging those values into the formula will yield the following:

where; PV = $1,000, rate = 0.07, n = 10, t = 30%

Using Excel, we can model what happens during each of the ten periods:

Year	PV	rate	FV	Tax (30%)
1	$ 1,000.00	7%	$ 1,070.00
2	$ 1,070.00	7%	$ 1,144.90
3	$ 1,144.90	7%	$ 1,225.04
4	$ 1,225.04	7%	$ 1,310.80
5	$ 1,310.80	7%	$ 1,402.55
6	$ 1,402.55	7%	$ 1,500.73
7	$ 1,500.73	7%	$ 1,605.78
8	$ 1,605.78	7%	$ 1,718.19
9	$ 1,718.19	7%	$ 1,838.46
10	$ 1,838.46	7%	$ 1,967.15
Tax				$ 590.15
Net ATFV			$ 1,377.01

future value of a tax-deferred account table

Notice how the tax is paid during the final period. In the United States, this is how the future value of a Traditional IRA would be calculated. We can represent the table above visually with the following chart:

future value of a tax-deferred account chart

Using an HP12C calculator, we can calculate the future value of a tax-deferred account with the following keystrokes:

[1000][PV]
[7][i]
[10][n][FV]
[.][7][*]

The formula can be rearranged as follows to find the present value of a tax-deferred account:

The present value of a tax-deferred account formula is usually only seen on tests which require you to calculate the present value of a tax-deferred account based on an initial investment an investor made in the past, given some current value in the future.

A copy of the Excel model can be found here.

How to Calculate the Future Value of a Tax-Free Account

Recall, that the formula utilized to calculate the future value of a lump sum is as follows:

Where:
FV = Future Value
PV = Present Value
r = rate
n = periods

Calculating the future value of a tax-free account incorporates the tax paid on the money prior to investing it in the tax-free account. We can account for the taxes paid by adjusting the present value for taxes:

future value of a tax-free account

In essence, the present value is reduced by the tax owed today and becomes the net amount invested. This net amount is then grown tax-free through all periods and no tax liability is owed when the money is withdrawn.

Assume you have a present value of $1,000, that will grow at a 7% rate for 10 years, and the initial tax owed is 30%. We can calculate the future value of the tax-free account by plugging those variables into the formula as follows:

where; PV = $1,000, rate = 0.07, n = 10, t = 30%

Using Excel, we can model what occurs during each of the ten periods:

Year	PV	rate	FV
1	$ 700.00	7.00%	$ 749.00
2	$ 749.00	7.00%	$ 801.43
3	$ 801.43	7.00%	$ 857.53
4	$ 857.53	7.00%	$ 917.56
5	$ 917.56	7.00%	$ 981.79
6	$ 981.79	7.00%	$ 1,050.51
7	$ 1,050.51	7.00%	$ 1,124.05
8	$ 1,124.05	7.00%	$ 1,202.73
9	$ 1,202.73	7.00%	$ 1,286.92
10	$ 1,286.92	7.00%	$ 1,377.01

future value of a tax-free account table

Notice how the initial present value is reduced by the current tax rate. In the United States, this is how the future value of a Roth IRA would be calculated. We can illustrate the table above visually with the following chart:

future value of a tax-free account chart

Using an HP12C calculator, you can calculate the future value of a tax-free account using the following keystrokes:

[1000][ENTER]
[.][7][*][PV]
[7][i]
[10][n]
[FV]

The formula can be rearranged as follows to find the present value of a tax-free account:

The present value version of the tax-free account formula is usually only seen on tests which require you to calculate the initial investment an investor made in the past, given some current value in the future.

A copy of the Excel model can be found here.

Traditional IRAs vs Roth IRAs

Many people are familiar with the different tax treatment between Traditional IRAs and Roth IRAs; unfortunately, often times most individuals are not sure which contribution type is right for them.

Typically, advocates for either type of IRA tend to elect 100% of their annual contribution limits towards their IRA flavor of choice.

Ultimately, if taxes never changed then mathematically it makes zero difference if you elected Traditional IRA or Roth IRA contributions, the ending balances would be the same.

Recall, that the future value of a present value today can be solved for with the following formula:

future value formula

Where:
FV = Future Value
PV = Present Value
r = rate
n = period

In order to determine the after-tax value of a Traditional IRA or a Roth IRA, a new quantity for taxes is added. The key difference is the order that the taxes are taken out, which becomes clearer when comparing the two formulas. Here is the formula for the after-tax value of a Traditional IRA:

after-tax value of traditional IRA

Where:
t = taxes

Comparatively, here is the formula for the after-tax value of a Roth IRA (which can also be referred to as the future value of a tax-free account):

after-tax value of roth IRA

Notice how the quantity (1 – t) is moved to the front of the equation, which makes sense given that Roth IRA contributions are taxed up front, and the remaining amount is invested. Since multiplication is cumulative, then the ending balances after paying taxes should be identical between both accounts.

Let’s assume that you invest $1,000 in a Traditional IRA growing at a rate of 7.00% for 10 years, when you retire your marginal tax bracket is 30%. Plugging those values into the formula for a Traditional IRA would yield the following:

where; PV = $1,000, rate = 0.07, n = 10, t = 30%

Your initial $1,000 contribution grew tax free for 10 years, and after paying a 30% tax in the tenth year you are left with $1,377.01. The table below illustrates the tax free growth for 10 years, the tax paid, and the net after-tax future value:

Traditional IRA
Year	PV	Rate	FV	Tax (30%)
1	$ 1,000.00	7.00%	$ 1,070.00
2	$ 1,070.00	7.00%	$ 1,144.90
3	$ 1,144.90	7.00%	$ 1,225.04
4	$ 1,225.04	7.00%	$ 1,310.80
5	$ 1,310.80	7.00%	$ 1,402.55
6	$ 1,402.55	7.00%	$ 1,500.73
7	$ 1,500.73	7.00%	$ 1,605.78
8	$ 1,605.78	7.00%	$ 1,718.19
9	$ 1,718.19	7.00%	$ 1,838.46
10	$ 1,838.46	7.00%	$ 1,967.15
TAX				$ 590.15
Net ATFV			$ 1,377.01

traditional IRA table

We can represent the data above in the following chart:

Let’s plug the same values into the Roth IRA formula to prove that they are identical:

where; PV = $1,000, rate = 0.07, n = 10, t = 30%

Despite starting with a lower initial investment since the tax with Roth IRA contributions are paid up front, the ending value is still identical to the Traditional IRA account:

Roth IRA
Year	PV	Rate	FV	Tax (30%)
1	$ 700.00	7.00%	$ 749.00
2	$ 749.00	7.00%	$ 801.43
3	$ 801.43	7.00%	$ 857.53
4	$ 857.53	7.00%	$ 917.56
5	$ 917.56	7.00%	$ 981.79
6	$ 981.79	7.00%	$ 1,050.51
7	$ 1,050.51	7.00%	$ 1,124.05
8	$ 1,124.05	7.00%	$ 1,202.73
9	$ 1,202.73	7.00%	$ 1,286.92
10	$ 1,286.92	7.00%	$ 1,377.01
TAX				$ –
Net ATFV			$ 1,377.01

roth IRA table

To reiterate, if your marginal tax bracket in the future is identical to your marginal tax bracket today, there is zero difference between a Traditional IRA and a Roth IRA (there may be a perceived difference due to emotional or cognitive biases).

Obviously, the future state of taxation is a huge assumption to make and the world is not that simple. There are a multitude of additional variables and factors that need to be taken into account in order to determine what blend between Traditional IRA or Roth IRA contributions makes the most financial sense for you.

Since there are exactly zero people on the planet who can accurately predict what the marginal tax brackets will look like when you retire (I’d be skeptical of anyone claiming that they can), having money in both account types will provide you with the maximum flexibility in determining your actual tax bracket when you retire.

Remember that the next time anyone says, “Roth IRAs are better than Traditional IRAs so I put 100% of my annual contribution limits into my Roth IRA”, or vice versa. Generalized advice, generally has good intentions, but produces generally bad outcomes, generally speaking.

Taxes aren’t the only variable that should be taken into account when determining the optimal Traditional IRA and Roth IRA blend. One should also consider the following:

what will your burn rate be when you retire
what will your projected federal tax bracket be
do you pay state income taxes
will you move to a state that has no income taxes
will you move to a state that does have an income tax
what is your current blend of qualified vs non-qualified assets
what proportion of your employer matching contributions into any qualified plans is made on your behalf

The list above, while somewhat lengthy, is nowhere near exhaustive despite the potential to get exhausted while thinking about it.

All of the concepts above are also applicable to the world of 401(k)s. From a taxation standpoint, Traditional IRAs (which are a type of qualified accounts) are taxed identically to Traditional 401(k) contributions. Similarly, Roth IRAs are taxed identically to Roth 401(k) contributions.

Other important subtleties that you should be aware of for Roth IRAs and Roth 401(k)s are the lack of required minimum distributions. RMDs do not apply to Roth IRAs or Roth 401(k)s which make them an extremely potent estate planning wealth transfer tool.

In my opinion, the best kept secret about Roth 401(k) contributions are the fact that the income limitations that apply to Roth IRAs, do not apply to Roth 401(k) contributions. You could make $1mm dollars a year and still contribute the IRS maximum into a Roth 401(k).

If you don’t have a Traditional IRA or a Roth IRA you can open one at Charles Schwab for commission free trading with an initial funding bonus of up to $500 by clicking here.

How to Calculate Present Value

The formula used to discount a future value to a present value today is as follows:

Where:

PV = Present Value
FV = Future Value
r = rate
t = time

Assume you would like to have a future lump sum of $10,000. How much would you have to invest today, if the initial contribution grew at required rate of 7.00% for five years? Plugging those values into the formula would yield the following:

The amount that is required today, in order to have $10,000 in the future will decrease as a function of either a longer time-frame, or a higher discount rate. Using Excel, we can model the amounts required given a specific time-frame or rate:

Year	FV	rate	PV
5	$ 10,000.00	7.00%	$ 7,129.86
10	$ 10,000.00	7.00%	$ 5,083.49
15	$ 10,000.00	7.00%	$ 3,624.46
20	$ 10,000.00	7.00%	$ 2,584.19
25	$ 10,000.00	7.00%	$ 1,842.49
30	$ 10,000.00	7.00%	$ 1,313.67

present value table

The data can be represented visually as well:

Viewing the chart above, you can see that the initial investment required today, decreases exponentially as a function of time.

Using an HP12C calculator, the present value can be calculated using the following keystrokes:

[10,000][FV]
[7][i]
[5][n]
[PV]

A copy of the Excel model can be found here

How to Calculate Future Value

The formula used to calculate the future value of a present amount today, is as follows:

Where:
FV = Future Value
PV = Present Value
r = interest rate
t = time

Assume you have a present value (PV) of $1,000, growing at a rate (r) of 7.00% for ten years (t), the future value would be calculated as follows:

Using Excel, we can model the amount of interest that is credited at the end of each year:

Year	Present Value	rate	interest	Future Value
1	$ 1,000.00	7.00%	$ 70.00	$ 1,070.00
2	$ 1,070.00	7.00%	$ 74.90	$ 1,144.90
3	$ 1,144.90	7.00%	$ 80.14	$ 1,225.04
4	$ 1,225.04	7.00%	$ 85.75	$ 1,310.80
5	$ 1,310.80	7.00%	$ 91.76	$ 1,402.55
6	$ 1,402.55	7.00%	$ 98.18	$ 1,500.73
7	$ 1,500.73	7.00%	$ 105.05	$ 1,605.78
8	$ 1,605.78	7.00%	$ 112.40	$ 1,718.19
9	$ 1,718.19	7.00%	$ 120.27	$ 1,838.46
10	$ 1,838.46	7.00%	$ 128.69	$ 1,967.15

FV table

The data can be represented visually as well:

As you can see, the amount of interest credited at the end of each year grows on an exponential basis.

Using an HP12C, the future value can be calculated using the following keystrokes:

[1000][PV]
[10][n]
[7][i]
[FV]

A copy of the Excel model used to calculate future value can be found here.