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Samuel Foote, famous British comedic actor of his time, was chatting with a member of the royal court. The entitled aristocrat complained bitterly of having been thrown out a second-floor window for cheating at cards. Foote’s advice? “Don’t play so high.”

One secret to successful retirement saving, in addition to getting started, is to avoid paying taxes, especially in high income tax brackets. When you put your retirement money into play at higher tax rates, the government gets more of it. If, instead, you can limit or “smooth” out your income, staying out of those high tax brackets, you’ll keep more of your money over time.

The conventional advice is to do your retirement saving in tax-advantaged accounts such as Traditional and Roth IRAs and 401(k)s. Your savings will simply grow faster when liberated from an annual tax levy. That conventional advice makes sense in almost all cases, and most of us have accepted it without much question.

But I recently found myself wondering about that conventional wisdom: Just how much better are tax-sheltered retirement accounts? How much faster does your savings grow in a retirement account than a taxable investment account? And is there a significant difference in the performance of different types of retirement accounts over the long run? How much does the choice of accounts really matter?

And, speaking of tax matters, what is the impact on your money of the types of returns those accounts produce? Does it matter if your investments produce primarily dividends — usually taxed at your marginal income tax rate as soon as they are received, or if they produce primarily capital gains — usually taxed at lower rates, and not until you actually realize those gains by selling securities?

I ran a series of retirement simulations to find out….

Research

For my analysis, I used a high-fidelity retirement calculator that automatically performs detailed tax calculations each year with all the relevant tax provisions, including inflation-adjusted tax brackets. It also computes Required Minimum Distributions (RMDs) from tax-deferred accounts after age 70. And it handles the taxation of capital gains, as they are realized, at reduced rates.

In order to focus on just a few variables, I created a simple scenario: A hypothetical couple that chooses to save for retirement exclusively in one type of account, holding a single type of asset class. They save into this one account for their entire working career, and then live off that same account, plus Social Security, during retirement.

The couple earns $75K annually over the course of their careers, and spends $50K annually on expenses, both while working and in retirement. Their Social Security benefit, equal to $24K in today’s dollars, starts at age 65. Their return on cash is 0%. And their return on investments is 6%. Inflation runs at 3%.

The couple starts saving at age 30, continuing until their retirement at age 65. Each year of their working career, they contribute $10K in savings to their single retirement account. I analyzed what happens when that savings accumulates in each of the three possible types of accounts: taxable, tax-deferred, and tax-free. I also investigated the difference between putting that money in investments that produce dividends only, or capital gains only, or a 50/50 mixture.

Results: Retirement Accounts

For each combination of account and investment variables, I ran the simulation up until the couple reached age 90, then recorded their ending net worth, in today’s dollars. Here are the results, the amount of money the couple has left at age 90, for each type of account and investment return:

The first thing to notice is that the tax-free account generally does best. Tax-free is better than tax-deferred in this scenario because it results in a level income stream that stays out of higher tax brackets. That said, the tax-deferred option is ahead until retirement (age 65), due to the way it reduces taxes: Contributions to tax-deferred accounts are subtracted from taxable income. But then the tax-deferred option loses out, because withdrawals from the tax-deferred account, including RMDs, push the couple into a higher tax bracket more often during retirement. (The average effective tax rate for the tax-deferred option is about 2.5% higher than the tax-free.)

Looking at the results above, we can also easily see that the tax status of your investment returns — whether primarily dividends or capital gains — does not matter for retirement accounts. That’s because withdrawals from these accounts, when they are taxed at all, are taxed at ordinary income rates. So it doesn’t matter whether the account growth is due to bonds producing dividends or stocks producing capital gains. The tax consequences are the same either way. And we see that demonstrated in the identical ending values regardless of the composition of the tax-free or tax-deferred accounts.

Results: Taxable Accounts

This is not true for taxable accounts, however. The results show that investments producing ordinary taxable income in taxable accounts under perform dramatically over the long haul. The taxable account with dividend income was worth less than one-half of the same account with capital gains. That’s because, not only are capital gains not taxed until securities are sold, allowing more time for investments to compound, but they aren’t taxed at all if you are in the lower two tax brackets. And, in fact, this couple spends most of their working and retired life in those lower 10% and 15% tax brackets.

Now, compare the ending value of that taxable account with 100% capital gains to that of the tax-free account. Remarkably, a taxable account with most of its growth coming from capital gains, if that growth is withdrawn in the lower two tax brackets, is essentially equivalent to a tax-free retirement account. That’s because, in either case, the growth is not taxed!

Also note that this particular couple would actually have been better off saving in a taxable account than a tax-deferred account, if they were willing to deal with the volatility of owning primarily stocks in that taxable account.

And, while most taxable accounts can’t outperform the average tax-free account, they do have one clear advantage: far fewer rules about what you can and can’t do with your money!

Am I suggesting that you forego the traditional retirement savings vehicles? Absolutely not! For most people, those accounts are the best starting point for retirement saving. And the additional rules and barriers for accessing that money are actually a good thing, if they provide motivation to leave that money alone and invest for the long haul.

Also, you’d rarely want 100% equities in your taxable accounts. That’s because at least one of those accounts should probably be serving as an emergency fund. You’ll need stable cash or bonds that you can draw on in a pinch without penalties and without regard for what the market is doing at the time.

Finally, equities themselves typically generate some dividends. But, even if you don’t follow this example to the extreme, there is much to be learned from it: Owning capital-gains-generating securities as much as possible in your taxable accounts can pay off big-time over the long haul, especially if you live in the lower tax brackets.

Conclusion

The conventional advice about retirement saving is correct, for the most part. Smart retirement saving is all about deferring and reducing taxes. You want to pay taxes later and you want to smooth your income, if possible, so you pay those taxes from lower tax brackets.

But you might not appreciate how important that is until you study the numbers above. A tax-smart approach to retirement saving and living can easily increase your ending net worth by 25-50% or more.

But that doesn’t necessarily require a tax-sheltered account. The conventional wisdom leaves out one surprising contender for tax-efficient retirement saving: For those in the lower tax brackets, a taxable account holding the right kind of assets — those that primarily generate capital gains — can be very nearly as effective as the best retirement account!

So, when it comes to your retirement money and taxes, it’s best “not to play so high.” Whether you choose to save in tax-advantaged accounts, or live in lower tax brackets, or both, your finances will do better in the long run.

And, just to be safe, I’d avoid cheating at cards too….

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