The Power of Tax-Deferred Compounding

In this hypothetical illustration, we'll analyze the scenario for a monthly contribution of $250 into a §403(b) plan that is earning 8% APR versus the same monthly contribution and earnings rate in a taxable investment with a 25% tax rate. 

*This hypothetical example is not intended to illustrate the performance of an actual investment. This illustration is not an indication or guarantee of future performance. The illustration is a hypothetical analysis that is calculated using a single compounded rate of return, which is highly unlikely as rates will vary over time, particularly for long-term investments. The illustration does not take into consideration any investment fees or expenses, which would lower performance.

A taxpayer saving in a taxable investment would first have to pay tax on the $250 earmarked for saving, netting only $187.50 for deposit each month. In 10 years, the taxable investment would have grown to $30,970 while the §403(b) investment would be at $34,531, net after taxes - a difference of $3,561.

The difference is that in the taxable investment, taxes were paid on all of the gains, thus reducing the amount saved. With the §403(b) plan, the entire investment was permitted to grow tax-deferred.

Over a period of 30 years, the difference is even more dramatic. Here the taxable investment grows to just $191,250 while the tax-deferred investment grows to $281,306 net after taxes. The difference is $90,055!

All the funds that were paid out from the taxable investment to cover the taxes were allowed to remain in the tax-deferred §403(b) investment to compound over all those years. With a §403(b) account, those funds were working for the investor throughout that entire period of time. And while §403(b) assets are subject to ordinary income taxes in the year distributed, investors may find themselves in a lower tax bracket at retirement than when they were working. This means the amount paid in taxes may be less. 

Distributions prior to age 59½ may be subject to a 10% IRS penalty.