James M. Poterba’s article attempts to explain with reasonably simple language, examples, and tables the complexity of various types of investments people often make to save for retirement. In the introduction, the author states that “this analysis looks only at taxes that are paid when funds are withdrawn or, in the case of taxable accounts, taxes that are due along the way” (Poterba 1). Poterba covers how different investment types are taxed differently, rates subject to change due to tax reform, how rates of return differ according to investment types such as bonds and equities, and the importance of periodically valuing investments.
Differences in tax rates at the time of contribution, during investment, and at the time of withdrawal may influence where people choose to invest their money towards retirement. Poterba defines implicit after-tax return as “the compound annual return that the individual would need to earn on a given amount of pre-tax earnings to achieve a given after-tax balance at the time of withdrawal” (2). In considering how to invest money, Poterba expresses the necessity of comparing the types of investments over a “long time horizon,” including 10, 30, and 50 years (2). The tables presented show comparisons of constant rates and varying rates in five types of investments, including Taxable Account Bonds, Roth IRAs, Traditional IRAs or 401(k) without an employer match, 401(k)s with a 50 percent employer match, and Taxable Account Stocks.
After-tax return for bonds, according to the author, generally offer higher rates of return when the money is invested in a tax-deferred account versus a taxable account (Poterba 3). The best rates for these types of accounts appears to come from 401(k)s with the employer match feature. Although there has been some discussion by other researchers that there could be financial loss if the taxation rate at the time of retirement is greater than when the investment in the account began, Poterba believes that for long-term investors, especially those with “substantial employer matching contributions when they contribute to tax-deferred accounts,” the length of the investment and employer-matching will not suffer a loss and still benefit greatly from their investment.
After-tax returns for equities such as stocks and mutual fundshave an advantage because they are not taxed on the current income tax rate, but on the historically lower capital gains rate (Poterba 4). The advantage for the investor in equities is that “capital gains are taxed on realization, and between the time of accrual and the time of realization, the government is providing the investor with an interest-free loan in the amount of the accrued tax liability (Poterba 4-5).
Finally, Poterba believes it is important for investors to reevaluate their investments from time to time to make sure they are on target towards the retirement savings goal. The investor should decide if changes need to be made in the type of investment or contributions to an existing account. For instance, Poterba writes, “the retirement wealth value of a stock held in a Roth IRA remains greater than that of the same stock held in a taxable account” (7). Table 4, Future Retirement Resources Generated by $100 Held in Stock, clearly shows the differences in the results of different types of investing, with time being one of the most important factors.
Poterba admits that his calculations in this article “over-simplify a number of features of the tax and saving problem,” especially individuals’ complicated tax circumstances, the “nature of returns,” and the view of the tax system “as a constant” (7). However, in spite of the simplification of some of the issues, Poterba’s article provides valuable information about some of the biggest issues investors should consider as they decide where to place money in saving for retirement.
Poterba, James M. (2004). Saving for Retirement: Taxes Matter. Boston College Center for Retirement Research. Web. Retrieved from http://crr.bc.edu/wp-content/uploads/2004/05/ib_17.pdf