Measuring the Efficiency of Tax-Favored Investments

Wood, Glenn; Attaran, Mohsen
August 1997
Journal of Financial Planning;Aug1997, Vol. 10 Issue 4, p91
Academic Journal
This article deals with the method of measuring the efficiency of tax-favored investments. Investments can be classified for income tax purposes into four basic categories: taxable, tax-free, tax-deferred, tax-deductible and deferred. Taxable investments have no basic tax advantages and are illustrated by many transactions. Most investors are well aware of the various categories of taxation and the tax advantages of qualified retirement plans. However, a method of measuring the tax efficiency of all the various approaches is not readily apparent. Furthermore, in comparing tax-free with tax-deferred investments, it is not always easy to know which is preferable. An additional complication is the proper evaluation of the ten-percent premature distribution tax associated with qualified retirement plans. The gain on taxable investments is taxed each year. Therefore, the after-tax accumulation of taxable investments is simply the amount that will accumulate at the after-tax rate. Deductible and deferred investments accumulate the largest after-tax amount for all periods. Taxable investments accumulate the smallest after-tax amount for all periods. The desirability of tax-free versus tax-deferred depends on the time period. For shorter periods, the tax-free approach is preferable. However, for longer periods, the deferral of the higher-interest return on the tax-deferred approach more than off-sets the advantage of tax-free income.


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