Magazine article The CPA Journal

Growth versus Income: Comparing "Apples and Oranges"

Magazine article The CPA Journal

Growth versus Income: Comparing "Apples and Oranges"

Article excerpt

Who was it who said that compound interest is the "eighth wonder of the world"? Whoever it was, he or she was among the few people who really appreciate the impact of long-term compounding.

An investor was curious about the long-term difference between letting money accumulate in tax-deferred growth stocks d versus fixed-income investments that generate taxable income. Others gave me cause to compare taxable and tax-exempt investments versus qualified plan investments such as a pension plan.

To answer these questions I used a Lotus 1-2-3 spreadsheet. From having done so, a few lessons were learned.

Adjusted Yield Rates Can Be Misleading

It's easy to compare a taxable bond investment to a tax-free investment where there is no deferral of taxes involved. You just need to adjust the after-tax yield for the investor's tax bracket Where a taxable investment pays a 6% return and the investor has an effective rate of 33%, the after-tax return is 4%. An tax-exempt yield of 4% or more is going to produce a higher net return, as long as you assume an equal risk factor for both investments.

But how can you compare a tax-deferred investment to a currently taxable investment? What about the impact of time? Stock funds are not subject to a tax until sold. If a $1,000 investment is compounded at 10% for 10 years, the result is about $2,600. If we assume a 30% tax bracket on the $1,600 of gain, the tax will be $480, and the after-tax investment will be worth $2,120.

What if you could find a fixed-income investment that paid 7% per year? It would be worth $1,967 after 10 years of compounding. The taxable stock investment results in more money than the tax-free investment with the same after-tax yield rate. Comparing after-tax rates doesn't give the full story. With longer periods of time and with higher assumed tax rates, the differences will be more dramatic.

The "real rate of return" is generally defined as the gross yield (income plus growth, minus the rate of inflation. Please note that the rate of return ignores taxes.

On the other hand the after-tax rate of return ignores inflation.

What is seldom discussed by anyone is the after-tax real rate of return. That's the after-tax rate of return minus the inflation rate. Table 1 presents a few comparisons where the gross rate of return increases by the same rate as the inflation rate. (Table 1 omitted)

As the rate of inflation increases, the after-tax real rate of return decreases, even though the nominal rate of return increases in exact proportion to the inflation rate.

However, if the tax burden can be deferred, the real rate of return will adjust for any inflation. Of inflation rates do not exceed about 5% to 7%.)

Making Long-Term Comparisons

Over time, inflation takes its toll in different ways depending on the type of investment and how taxes are being deferred.

In order to compare tax-deferred investments and taxable investments for periods of more than a ear, I created a worksheet template to make the projections for up to 25 years. I made calculations for four types of investments: fully taxable in the year income is received, fully tax exempt in the year received, tax deferred on the income until the end of the period, and investments held in a qualified retirement plan. The results, as shown in Table 2, are examples of one set of possibilities to compare the after-tax inflation adjusted benefits of the four different types of savings alternatives for up to 25 years. (Table 2 omitted)

The "balance at 25 pears" is the amount left in each account. The "balance after tax" is the amount that would be left if the total account were cashed in and any deferred taxes paid. In the first two columns, the taxes have already been taken into account. In the third column, it's assumed that the balance is cashed in and taxed at a long-term capital gain rate of 28%. For the qualified retirement plan column, the initial investment is "grossed up" to reflect the pre-tax equivalent of the after-tax investment in the other three columns. …

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