One of the challenges in determining the value of a particular financial decision is selecting the criteria for measurement. Calculating the impact of taxation on accumulation provides a good example, because while some of the factors are arithmetic, their impact can be geometric. This is best illustrated by the compounding – both for and against savers – that occurs when taxes are included.

Let’s start with a basic example:

Deposit $10,000 to an account paying dividends at 5% annually. In 10 years, the “magic” of compounding has increased the account’s value to $16,288.95.

FIGURE 1               Beginning Balance:……………………………                 $10,000

Annual Dividend Rate:……………………….. 5.00%

Dividend Tax Rate:. ………………………….. 15.00%

Cumulative Tax Cost:                 $943.34

Because the simple arithmetic dividend calculation is applied to a larger balance, the same rate of return generates an increasingly greater gain each year. But what happens if we add taxes to the discussion?

Using a dividend tax rate of 15%, here are the taxes that would result from 10 years of accumulation. (See Figure 1)

This calculation assumes the individual paid the dividend taxes “out-of-pocket”; i.e., the money deposited in the account was left to accumulate, while the additional tax was paid from other household funds. This method probably reflects real-life for most investors, as they don’t withdraw funds from the account to pay the taxes, but rather make up the difference from other sources. As you can see, the annual tax cost “compounds” right along with the growing dividends. From this method, it might be possible to calculate an after-tax return as follows:

Account Balance – Cumulative Tax Cost = Net Balance.

$16,288.95 – $943.34 = $15,345.61

If a future value calculation was made, the net annual rate of return, including taxes, would be 4.38 percent. But is this really accurate?

FIGURE 2               Beginning Balance:……………………………                 $10,000

Annual Dividend Rate:……………………….. 5.00%

Dividend Tax Rate:.   …………………………. 15.00%

Cumulative Tax Cost:……………….. $943.34

Net Balance:…………………………… $15,162.14

Net Annual Return:                    4.25%

Paying the taxes out-of-pocket creates an opportunity cost. What could that money have been worth if it hadn’t been used to pay taxes because of a decision to invest in this particular account?

A more accurate calculation is derived by using the dividends to pay each year’s tax. (See Figure 2)

The net balance and net annual return are both lower using this calculation, and this method provides a better picture of what is really happening, even it doesn’t reflect how most savers pay the taxes on their accumulations.

As a way of making the illustration “more accurate,” some economic models might call for the tax to be paid out-of-pocket (reflecting real-life) – but with a higher calculation for opportunity cost. Here’s the logic:

Money paid as taxes represents a 100% loss to the account holder. Those dollars will never come back to the account holder or generate a return. Thus, any investment – even a risky one – has a better chance of delivering a return compared to paying taxes. So what if the rate of return for opportunity cost on the dividend taxes was 10%, representing the possible returns from a more volatile investment vehicle?

Three different calculations, each of which could reasonably be said to represent financial reality. Yet the after-tax return numbers range from 4.38 to 4.03 percent. Applied to $10,000, the difference isn’t much. But applied to $1 million, the difference could be around $65,000.

Ultimately, this exercise isn’t about determining which calculation format is best. Rather, it should make you more aware of the broad impact taxation can have on accumulation. On-going taxation on accumulation is one of the reasons many individuals select tax-favored qualified plans for their retirement saving. (Of course, pre-tax contributions and tax-deferred growth also have tax issues as well.) An automatic question for savers and investors should always be “What is the tax treatment on this account?”

Elozor Preil is Managing Director at Wealth Advisory Group and Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS).  He can be reached at epreil_wagroupllc.com

By Elozor Preil