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I'm not sure I understand the concept of "tax-free inside buildup."

From what I understand, life insurance, annuities and IRAs (both Traditional IRAs & Roth IRAs) benefit from "tax-free inside buildup." This essentially means that they are invested on a tax-free basis. But isn't it true that certain contributions to these devices are non-deductible?

I'm not sure what the term is intended to convey. If an example can be provided that would also be helpful.

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The term is intended to convey that there aren't annual tax bills for having that investment option. Generally, investment choices may be tax-deferred like Traditional IRAs where once the monies are removed then they are taxes or tax-free like Roth IRAs where the money is withdrawn without having to pay any taxes.

Imagine you own $10,000 worth of shares in a mutual fund that pays out 3% each year in dividends and has zero capital gains. There are $300 each year coming out that can be re-invested but if the shares are held in a taxable account then there are taxes to be paid on the distributions. If the shares are held in an IRA, then there isn't that tax bill each year.

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Think of it as a "tax shelter." The term indicates that investment earnings are not taxed while the assets remain within the account.

Practical examples:

Account a.) $10,000 is put into a regular investment account.

Account b.) $10,000 is put into a tax-sheltered 401(k) account.

In account a, dividends and capital gains are subject to taxation. If account a invests in VFIFX and earns 20%, when the assets are sold, it will be taxed as capital gains. 85% (assuming 15% capital gains tax) of 20% is a 17% gain.

In account b, the investment earning are not subject to taxation. If account b invests in VFIFX and earns 20%, the assets can be sold with no taxation for a 20% gain.

While the math above isn't exact, it illustrates the principle.

  • Does this mean that when Account B is taxed, the tax will be levied on the $10K investment. But in Account A, the tax will be levied on the investment PLUS the earnings (whether through interest or dividends) of the account? – user20687 May 4 '15 at 20:41
  • @franklin The tax is only levied on gains under the doctrine of constructive receipt. The $10k would have already been taxed before making its way into the investment account. – oBreak May 8 '15 at 19:19

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