How Tax-Advantaged is Tax-Deferred?
As I work with clients, I notice more and more couples approaching retirement with very large balances saved in their retirement accounts. This is wonderful. It takes a lot of discipline and commitment to save for the future and many folks are doing a great job.
However, these retirement accounts come with restrictions that can limit choices if the owner is less than 59 years old. They can also make tax planning an issue in later years. This always leaves me wondering why brokerage accounts aren’t used more often. It also leaves me wondering if tax-advantaged accounts are as advantaged as we are led to believe.
With that in mind, I created a case study between two young fictional savers and examined the tax liability throughout their lives. Before we get to that result, here is a breakdown of tax deferred accounts, brokerage accounts, and common wisdom.
Tax Deferred
Introduced through the Revenue Act of 1978, tax-deferred accounts, including the well-known 401(k), allow employees to defer taxation on income set aside for future use. This innovative approach not only incentivizes long-term savings but also provides a powerful tool for wealth accumulation.
Since then, tax-deferred accounts have grown to be the preferred type of retirement savings. By the end of 2023, approximately 63% of individual account-based retirement savings in the U.S. were held in tax-deferred accounts. (1)
Taxable brokerage
Taxable brokerage accounts, on the other hand, date back much further. Technically, brokerage accounts existed along with the very first public stocks, but in the U.S. the first of these accounts emerged in the late 18th century. (2)
Brokerage accounts are a type of taxable account that can hold different types of assets; most commonly used to hold cash, stocks, bonds, and mutual funds. The key difference with a taxable brokerage account is that it is taxed as it grows. There is no “tax advantage” when you invest in a taxable account and taxes are not deferred.
More on taxable accounts here: The Overlooked Account
Obvious choice
Usually, when investors think about retirement savings, tax-deferred accounts are the go-to choice. The tax advantaged feature of these accounts are a primary benefit, but investors can also enjoy the ease of contributing directly from their paychecks. These types of accounts can also provide broad options for investing and, once contributions are set up and a portfolio is chosen, require very little upkeep for most people.
However, there are drawbacks for these types of accounts. Most notably is the lack of liquidity. Most tax-deferred accounts come with restrictions on when and why you can begin taking withdrawals. A violation of these rules is met with additional tax penalties (and can ruin the tax deferred benefit). Most savers don’t mind these restrictions, though. After all, these accounts are primarily used for long term savings towards retirement.
The second most significant restriction to these types of accounts is contribution limits. Tax deferred accounts usually cap the amount an investor can contribute. However, these limits can be very generous. If you end up running into these limits, you’re probably saving plenty for retirement.
Honorable mention
So if tax-deferred accounts are a favored, efficient, and tax advantaged way to save for retirement, is it worth considering anything else? Say it with me; the common refrain of personal finance: “it depends.”
Brokerage accounts (mentioned above) don’t share the same tax advantages as tax-deferred accounts. Brokerage accounts are taxed anytime dividends or interest is received. Further, whenever investments are sold at a gain in a brokerage account, capital gains tax will be due.
However, just as with tax-deferred accounts, there are trade-offs. In exchange for the tax inefficiency of brokerage accounts, there are some benefits.
The primary benefit of brokerage accounts is liquidity. There are no restrictions as to when you can access the money in your account. You can contribute, invest, trade, withdraw as much and as often as you like. Other benefits include limitless investment options and no limit to contributions. It is as permissive as investing can get… but the taxes.
Tax efficient-ish
Yes, growth in a brokerage account is taxed, but there are some common misunderstandings of how this happens. Let’s break it down.
First, yes, contributions go in after-tax. That means contributions do not enjoy the same pre-tax treatment of tax-deferred contributions.
Invested money becomes “cost basis.” This is important because you are not taxed on that amount ever again! If you invest $100 (after-tax), that $100 can be withdrawn tax-free. It’s more complicated than that, but that’s the gist.
Any interest received from assets in a brokerage account are taxed at income rates. Interest is usually received from bonds or cash in the account. If you’re in the 22% tax bracket and earn $100 in interest, you will owe $22 in taxes. However, it is important to note that the $100 is added to your cost basis if it is reinvested.
Any qualified dividends will be taxed at beneficial rates; 15% for most people. You guessed it, these dividends will then be added to cost basis if reinvested.
If you sell an investment, you will be taxed on only the gain, not the basis. Also, the gain can be taxed at preferential rates (15% for most) if the investment is held for longer than a year. Also, you guessed it, this amount is added to basis if reinvested.
Finally, unqualified dividends and any gain from assets held for a year or less will be taxed at income rates. One more time; this amount is added to basis if reinvested.
Bottom line: you will only be taxed once you receive any form of interest/dividend or sell at a gain. Your basis is immune and you will either be taxed at your income rate or a preferential lower rate. Finally, all taxed amounts are added to your basis and immune from taxation again.
Tax advantaged-ish
Back to tax-deferred accounts. Believe it or not, it isn’t all good news when it comes to the tax treatment of tax-deferred accounts. There are some trade-offs. The tax treatment is much simpler; let’s break it down.
Contributions to tax-deferred accounts are made tax-free. The contributor will not owe income tax on the amount contributed.
If made pre-tax (typical), contributions do not create any basis in the account.
All withdrawals, if made within the rules, are taxed at the normal income tax rate.
The rub
Notice anything? While tax-deferred accounts are considered much more tax efficient, there is no benefit of paying lower tax rates on dividends or capital gains. There is usually no basis and ALL withdrawals are taxed at income tax rates.
But how does this play out?
Case study
Let’s consider two individuals, Ken and Bob. Both are 18 and starting their new careers and eager to save. Ken is aware of the tax advantages of a 401(k) and Bob favors the flexibility of a brokerage account. They both begin investing $3,000 a year towards retirement. Ken invests everything in his 401(k) and Bob to a brokerage account. They both retire at 65, receive average social security, and begin withdrawing 6.5% of their savings a year. Here are some other assumptions:
All figures, including tax rates, tax brackets, standard deductions, and average social security amounts are inflated at 3% annually.
Current tax rates are used. This assumes TCJA tax rates become permanent.
85% of their social security is taxable.
They both invest everything in a S&P 500 ETF and hold (no trading).
No match is considered for Ken’s 401(k). This is because we are comparing tax treatments between a 401(k) and brokerage. If you are offered a match from your company to invest in a 401(k), you should very seriously consider taking it.
When Bob retires, he takes annual dividends directly and sells shares to fulfill his need of 6.5%. The shares are sold pro-rata between basis and growth.
All dividends from the S&P 500 ETF are qualified.
Returns of the S&P 500 are based on average historical data: 8.50% growth (3) and 1.82% dividend yield (4).
Both Ken and Bob live to age 90.
The results
Would it shock you to learn that Bob pays less taxes than Ken over their lifetime?
Ignoring the timing of their tax burdens, the total amount of taxes paid during their lifetimes are:
Bob: $1,226,107.69
Ken: $1,249,236.81
Difference: $23,129.17
But why? Remember, Bob experiences only qualified dividends and long term cap gains tax from his investments. Both are a flat 15%. Ken, on the other hand, enjoys tax free contributions, but must pay his marginal tax rate in retirement on ALL distributions. As it turns out, Ken ends up in the 22% marginal tax bracket whereas Bob’s stays in the 12% bracket. This is because Bob’s only taxable income is his social security. Also, Bob’s brokerage withdrawals are a mix of 15% on growth and 0% on his cost basis.
Other aspects to consider
So Bob paid less over his life in taxes. He also experienced a few other benefits:
Flexibility: As mentioned, Bob wanted the flexibility of a brokerage account. He ended up holding everything for retirement, but he could have accessed his savings at any time penalty free. This is an immeasurable, qualitative benefit. Yes, Ken saved more in taxes while making contributions, but his savings was locked up until he turned 59.
Inheritance: This is the greatest benefit of Bob’s strategy. Both Bob and Ken pass away at age 90 with almost $7,500,000 left in their accounts. While they leave the same amount behind for their heirs, there is a significant difference in how these amounts are taxed. Ken’s heirs will receive his $7,500,000 and the tax burden along with it. They will have to pay taxes on everything they withdraw at their income tax rate. Bob’s heirs, on the other hand, will inherit his $7,500,000 at a stepped-up basis. Yes, that means they receive a $7,500,000 cost basis! This makes the inheritance nearly tax free.
If Bob and Ken’s heirs are in a 22% tax bracket, the tax adjusted difference in these inheritances is over $1,600,000. If you intend to leave investments to your heirs, doing so in a brokerage account is a very good way to eliminate tax burden for your heirs.
I’m surprised, too
When I created this case study, I simply wanted to compare how these two types of accounts were taxed. I wanted to support my point that brokerage accounts can be tax efficient and created a case study to support that idea. Bottom line; I did not expect Bob’s lifetime tax burden to be lower than Ken’s. I did expect it to be close, but not less.
I’m as surprised as you are. That said, I should highlight a few real world aspects to this study:
While Ken’s experience is very typical with 401(k) accounts, I did create an ideal tax situation for Bob. Bob invested in a low cost ETFs (just like Ken) and kept it until retirement. Any trading within his account, short term withdrawals, or ownership of interest bearing assets would have likely increased his tax burden.
Bob handled his brokerage account in a very efficient way. It should be noted than most people would not act in the same manner. If a normal person’s brokerage eclipsed $1,000,000 or more during their working years, temptation would likely induce that person to begin spending more or purchase an asset that they would otherwise not consider. It’s difficult to leave liquid savings alone!
Time Value of Money: While Bob’s total lifetime tax burden is lower than Ken’s, the timing of the taxes does matter. For instance, Bob paid $660 in taxes annually on his $3,000 contributions. Ken did not. This is a benefit to Ken, but it isn’t a simple difference of $660. That is because any financial benefit is more valuable the sooner you experience it. For instance, if Ken saved or invested his $660 tax deduction, his account would have grown much faster than Bob’s. That $660 invested at age 18 would have been worth more than $25,000 by the time they reached age 66. Time value of money does matter.
Math is math
Behavior and practicality aside, this is all just math. In the real world we likely wouldn’t think to invest 100% of retirement savings into brokerage accounts, and I’m not saying that is the answer. However, many folks do put 100% of their retirement savings in 401(k) accounts and IRAs. While doing so provides for greater security in the long run, savers can potentially miss out on liquidity and other benefits available to brokerage accounts before they move into retirement years. And, as we’ve seen, investing in those “tax-disadvantaged” accounts doesn’t cost as much as common wisdom believes.
Sources(1) Investment Company Institute. Investment Company Fact Book. 2024. Investment Company Institute, https://www.ici.org/research/reports/2024_factbook.(2) M1 Team. "The History of Brokerages." M1 Blog, 6 Dec. 2018, M1 Finance, https://www.m1finance.com/blog/the-history-of-brokerages.(3) YCharts. "S&P 500 Annual Return (I:SP500AR)." YCharts, Standard and Poor's, 5 Feb. 2025, www.ycharts.com/indicators/s&p500annual_return.(4) YCharts. "S&P 500 Dividend Yield (I:SP500DYT)." YCharts, Standard and Poor's, 5 Jun. 2025, www.ycharts.com/indicators/s&p500dividend_yield.Disclaimer: The information provided in this blog is for general informational purposes only and does not constitute financial, investment, legal, or other professional advice. While we strive to ensure the accuracy and completeness of the content, we make no guarantees regarding its reliability or suitability for any particular purpose. Readers should consult with a qualified financial advisor before making any investment decisions. As a fiduciary Registered Investment Advisor (RIA), we are committed to acting in your best interests. However, past performance is not indicative of future results, and all investments carry risks, including the potential loss of principal.
