The other avenue I was referring in the earlier section where you would have more control over your investments are the IRA schemes which you can purchase any time during the year (there is a mad rush to purchase these instruments before you file your returns for the previous year, but this is panic investments and herd mentality). The withdrawal features of IRA schemes remain the same i.e., after your age of 59 ½ years. The limits for them are lower compared to 401K. From tax treatment perspective IRA is pre-tax now and tax later and works like 401K, whereas Roth IRA is invested from your post-tax money and will not be taxed upon withdrawal. Below illustration shows how each of these schemes would compare and the numbers speak for themselves on which one would be better for you.
Comparison between Taxed investment and tax-free withdrawals or tax-free investment and taxed withdrawals
It is always a dilemma to determine if the tax now schemes are better compared to Tax Later schemes. Before we delve into this topic, we need to understand what these schemes offer from a taxability perspective. Few investments will help you save tax upfront and claim in the current tax year (or immediately preceding previous tax year). The tax incidence for such schemes is usually upon withdrawal on the complete amount. These are called Tax Later Investments. Tax incidence is exactly the opposite for Tax Now Investments. You will invest with your post-tax money (i.e., you will not get any tax deduction on your money during the current tax year) now and when you withdraw the entire proceeds would not be taxed.
Table below explains the difference in the amount of tax that you would need to pay in each case.
Assumptions:
- Tax Rate is 22% in 1991 and 2021.
- Post Tax CAGR in both cases is 7.5%
Tax Later
- You Invested $10,000 in 1991.
- You got a savings of $2,200 in 1991 when you filed your taxes. Your effective investment is $7,800.
- After 30 years, your investment grew to $87,745. You pay a tax of $19,304 on withdrawal.
Tax Now
- You Invested $10,000 in 1991.
- You got a savings of $0 in 1991 (you used your post-tax money).
- After 30 years, your investment grew to $87,745. You pay a tax of $0 on withdrawal.
Table 5: Comparing Tax Now and Tax Later Investments
| Age | Date | Tax Later – Amount Invested | Tax Later – Tax Saved/ (Paid) | Tax Now – Amount Invested | Tax Now – Tax Saved/ (Paid) |
| 30 | 1/1/1991 | ($7,800) | $2,200 | ($10,000) | $0 |
| 60 | 1/1/2021 | $68,441 | ($19,304) | $87,745 | $0 |
| CAGR | 7.5% | 7.5% |
Depending on your current objective you will need to decide if you need to reduce your tax burden in the current or previous tax year and pocket the money now. If the tax rate remains unchanged, from a financial perspective both offer you the same growth for your investment (i.e., CAGR is the same for both). From a tax outgo perspective however, you would save a minimal tax now but end up paying a significant tax later.
