“I became an investor (as opposed to a saver) 12-15 years ago.” writes Jim Taylor. “I keep reading advice columns that talk about keeping equity investments in non-retirement accounts and income investments in retirement accounts. The logic given is that in a retirement account you lose the capital gains tax break when you withdraw. Has anyone actually run the numbers on this? It seems to me that the higher historical returns for equities would offset the tax disadvantage. My gut feeling is that taxes push people’s hot buttons. It seems that the more money people have, the more they will go out of their way to reduce or avoid taxes….even if it means they get less after-tax income.”
Well, you’re right and wrong in my view. First, of course, it’s quite true that people have lost a fortune, over the years, trying to avoid taxes. So it’s certainly possible to go overboard with this.
On the other hand, Warren Buffett would be worth barely $2 billion today — if that — instead of his current $15 billion and change, had he racked up exactly the same compounded return, only exposed the gains to taxation once a year rather than buying and holding. So there is definitely something to be said for taking taxes into account in your investment strategy.
Beyond that, the answer to your question is very easy and very hard. The easy part is doing the numbers. The hard part is knowing what assumptions to use. What’s your tax bracket now — and what do you think it will be when you’re 60 and 70 and 80 and 90? How heavily will capital gains be taxed? What rate of return will you earn on equities going forward?
If you could make 25% a year on equities over the long haul, then the tax-sheltered account would fare magnificently. You’d be right: Forget what those dumb columnists tell you. Buy and sell all you like under the tax shelter of an IRA, avoiding any tax until you withdraw the money, racking up spectacular returns along the way. Why settle for 8% in your IRA when you can get 25%? Or even 10%? (Except that if the 8% is safe and the 10% isn’t, maybe the 8% is not so bad after all?)
Here’s the thing. If you plan to have any high-income producing assets, whether high-rated corporate bonds or REITs or utility stocks — then the columnists are right. Those are best kept in the retirement account, by and large, because you defer the income tax and get the government’s share of the income working for you, too.
Equities, meanwhile — especially the riskier ones and nondividend payers — should be held in your own account, because they are already tax-deferred. Their appreciation is not taxed unless you sell them (see Warren Buffett, above). What’s more, if you do have big gains, they will likely benefit from a capital gains tax break when you finally sell them. Within a retirement plan, by contrast, they will eventually convert to higher-taxed ordinary income as you withdraw the money.
What’s more what’s more: if you’re the charitable type, you can use highly appreciated securities to your advantage tax-wise — if you own them in your own name but not in a retirement account. And what’s more what’s more what’s more: those stocks that crash and burn (and we all have some) can provide a tax benefit in your own account. In a retirement account, it’s wasted.
If you had to put 100% of your money one place or the other, it could make sense to put it all in a tax-sheltered account. But for those of us lucky enough to own securities both in retirement plans and directly, taxes make the following proposition very fair, in my view: keep your riskier securities in your own name and your safer, higher-yielding ones in the tax-deferred account.
Or as the sailors say, navigating those buoys: High of Flight: Own Outright. Safe Old Nerd: Tax-Deferred. (Well, something like that.)
Quote of the Day
The only money that's tainted is money that taint mine or taint enough.~an old Georgia governor
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