Archives For Taxes

Bonds are typically less tax efficient than stocks, leading to a common recommendation to hold bonds in retirement accounts and stocks in taxable accounts. This article challenges this advice for certain investors.

This article applies if you follow a plan devised by Quality Asset Management, or:

  1. You optimize your use of bonds: Income during stock declines and no other use.
  2. Your stock investments are highly diversified globally, with no market timing and no individual stock selection.
  3. Your stock investments have high average returns and a low turnover (i.e. limited annual sales of stocks; e.g. index mutual funds).

Bonds are less tax efficient than stocks

The notion that bonds are less tax efficient than stocks is the basis for the idea that bonds are a better investment to shelter from taxes, by putting them into retirement accounts. This notion is correct as seen in the table below:

  Bonds (mainly interest) Stocks (mainly capital gains)
Taxation frequency Done every year Mainly deferred to sale. Index funds hold each stock for a number of years on average.
Tax rate Ordinary income tax rate Mainly long-term capital gains

A deeper analysis can challenge the conclusion above.

Considering investment horizon

Given that you use your bonds whenever there are stock declines (assumption #1 at the top), as soon as you experience a stock decline, you would withdraw the money, and would not be able to put it back in. This would result in losing the retirement account tax benefit forever, due to a single stock decline.

There is a sophistication that can help you get around this limitation, but is not very practical due to its complexity and excessive trading.1

Comparing tax amount instead of tax rate

While the tax-rate of bond investments is higher than stocks investments, there is an offsetting factor. The average growth rate of stocks is much higher than bonds, magnifying the total tax amount , and offsetting the benefit of the low tax rate . A full analysis may become complex, given the combination of long-term gains and short-term gains, dividends and capital gains distributions. Instead, I will provide a simplified example to demonstrate the point:

  1. The tax on a bond fund with 5% interest at about 40% tax rate (federal 35% & state 10% minus a deduction of state taxes from federal taxes) is 2%.
  2. The tax on a stock fund with 15% growth taxed at 10% tax rate (federal 15% & state 10% minus 15% for the fact that taxation is mostly deferred) is 1.5%.

The faster growth of the stock investment keeps raising the tax amount. If we start with a $10,000 investment, here is the tax amount over a few years (under the assumptions above):

Tax on $10,000 investment in bonds vs. stocks Difference
Year Bonds (5% growth 2% tax) Stocks (15% growth 1.5% tax)
Principal Tax Principal Tax
1 $10,000 $200 $10,000 $150 -$50
2 $10,300 $206 $11,350 $170 -$36
3 $10,609 $212 $12,882 $193 -$19
4 $10,927 $219 $14,621 $219 $0
5 $11,255 $225 $16,595 $249 $24
6 $11,592 $232 $18,835 $283 $51

The faster growth of the stock investment resulted in a higher tax amount within 5 years, despite the lower tax rate.

While this example ignores some variables, and has simplified assumptions, it demonstrates the point that higher growth can result in higher taxes, even when the tax rate is lower and most of the taxation is deferred.

Summary

The rule of thumb: “hold bonds in retirement accounts, due to their worse tax treatment”, does not hold for investors that optimize their bond and stock investments, for two main reasons: (1) when withdrawing bonds from the retirement account during stock declines you lose the tax benefit forever; (2) the higher growth of stocks results in higher tax amounts over time.


1 Say you need $10k from bonds during a stock decline. You can do the following:

Taxable account: sell $10k stocks

Retirement account: sell $10k bonds, buy $10k stocks

Once your stock portfolio recovers, you can move the stocks in the retirement account back to bonds (sell $10k stocks, buy $10k bonds).

Disclosures Including Backtested Performance Data

If you have high income, you may know that a Roth IRA is off limits for you. You cannot contribute to it or convert a Traditional IRA to it. Starting in 2010, Roth IRAs will be accessible to everyone. This article can help you decide whether and when to convert your Traditional IRA to a Roth IRA.

Before continuing, note that this article is not intended to provide a full review of IRA tax laws. You are encouraged to consult your CPA before making tax related decisions.

How can you contribute to a Roth IRA? The new law does not remove the income cap on contributing to a Roth IRA, but it does remove the income cap on converting a Traditional IRA to a Roth IRA. This means that every year you can contribute to a Traditional IRA and the next day convert the contribution to a Roth IRA, essentially resulting in a contribution to your Roth IRA.

Here are a few characteristics of IRAs (referenced later as #1 to #5):

Characteristic Traditional IRA Roth IRA Taxable
1 Are investment taxes1 imposed? No, investments are tax free while the money is in the account Yes
2 When is income tax paid? When money is taken out When income is earned
3 Can income tax be paid from outside the account? No Yes N/A
4 How long can money stay in the account? Up to age 70½, then withdraw throughout life For life, then withdraw throughout life of heirs Forever
5 How soon can money be withdrawn from the account? Age 59½; disability; death; up to $10,000 for first home for you, your parents, children or grandchildren; unreimbursed medical expenses above 7.5% of AGI; higher education; medical insurance after getting 12 weeks of unemployment payments due to losing your job; as a result of an IRS levy; or equal payments at least till age 59½ and at least for 5 years, but:
Roth Contributions: Can be withdrawn any time.
Roth Earnings & Rollovers: Cannot be withdrawn for 5 years after the first ever contribution to a Roth IRA.
Anytime

Maximize IRA Balances: Both IRA types are free of investment taxes for as long as the money is in the account (#1). Therefore, you should maximize contributions of money designated for retirement into IRAs, and minimize withdrawals. Given #5 above, you can maximize Roth IRA contributions regardless of when you may need the money (with limitations on withdrawal of earnings).

Maximize Roth IRA Balances, with several exceptions. The Roth IRA provides the following benefits:

  1. Reduced Taxable Portfolio: When paying income taxes from outside the account, you have more money grow free of investment taxes (#3). If you are at the 33% tax bracket and you convert today using taxable money, you save investment taxes on 33% of the IRA balance. If you are taxed on 4% of your portfolio per year on average, at about 30% combined federal & state tax rate, it equals 1.2% in taxes on 33% of the IRA balance = 0.4% saved per year.
    Put differently, if you take money out of the IRA with your income tax rate at 33%, you are left with $67 on every $100 withdrawn. By paying the tax from outside the IRA earlier on, you increase your balance by 49% (100/67-1), and substantially increase the amount that is free of investment taxes.
  2. Money Growing Longer with the Tax Benefits: You can keep your money in your Roth IRA for your life expectancy beyond age 70½ + the age difference between you and your heirs (#4), typically providing 20-50 extra years free from investment taxes.
  3. Reduce Taxes During Stock Declines: When your IRA balance shrinks during stock market declines, any dollar amount you choose to convert will represent a larger percentage of your IRA balance, allowing you to convert a greater portion of your money at the same tax rate. If your IRA has a diversified long-term stock investment, this is an opportunity to save on taxes.
  4. Convert Less Money at High Tax Rates: As your IRA balance grows, more of the amount that you later withdraw or convert to a Roth IRA gets pushed into higher income tax brackets. Given that IRAs tend to grow much faster than the expansion of tax brackets, converting earlier on can keep more of the converted amount at lower tax brackets. This can be huge. If your portfolio tends to double every 5 years compared to the expansion of tax brackets (~14% long-term difference), any IRA that is likely to stay invested for more than a few years, is likely to cost a lot more to convert in the future (even when income tax cost is correctly calculated as a percentage of the account balance).
  5. Shield from Uncertain Future Tax Rates: Given that current tax rates are known while the future is unknown, it is more conservative to pay the taxes in today’s known rates, as opposed to risking being subject to higher future rates. Any risk you can remove may help you better plan for your retirement.
  6. An extra incentive in 2010: Only in 2010, the payment of taxes on converted amounts can be deferred by an average of an additional 1.5 years (½ the tax is paid in tax year 2011, and ½ in 2012). If your portfolio grows on average by 15% per year, the money used to pay the income tax on the conversion can grow by an average of 23.3% over 1.5 years, reducing your effective tax rate by 18.9% (=(1-1/(1+23.3/100))*100). For example, converting in 2010 at the 28% tax bracket, would be equivalent to converting any other year at 22.7% (28*(1-18.9/100)).
Rule of Thumb : You should not convert your Traditional IRAs to Roth IRAs (or contribute to a Roth IRA), if you expect your tax rate to be:

  1. Much lower (typically 10% less or more),
  2. In very few years (typically 5 or less).

Otherwise, you probably should convert, since the growth of the IRA balance can push you into higher tax brackets2, negating the benefit of waiting. In addition, if you have money outside your IRA for paying the income tax, by paying it now, you shield the tax amount from future investment taxes, making the case for conversion soon even stronger.

When in the Year should you Convert to a Roth IRA? It is most beneficial to convert your Traditional IRA to a Roth IRA right in the beginning of the tax year (January 2 nd ), for two reasons:

  1. Your converted money can grow an additional 1.3 years until you pay the taxes on the conversion (4/15 of the following year).
  2. You can undo the conversion (officially named: “recharacterizing”) until your tax filing deadline 4/15 (or 10/15 with an extension). During these 1.3 years, you can choose to undo the conversion if the account declined, and redo it next year at a lower cost.

Convert More than Planned. If you have any doubts regarding the amount to convert, a beneficial strategy could be to convert the full IRA (or at least the most you could possibly expect wanting to convert). Up to 4/15 of the following year, you can undo any part of it, providing you maximum freedom to leave converted as much or as little as makes sense, with the benefit of hindsight. This is especially useful in 2010, given the benefit of extra tax deferral, and while the stock market is so low.

Advanced Planning (not typical). There is one reason to not convert the full account. If you are almost certain you want to convert a lot less than the full account, even if its value jumps substantially, you could convert, say, half of it. In case the account drops in value during the year, you can undo the full conversion, and reconvert the second half right away. Without this tactic, you would have to wait until next year, and at least 30 days from the previous conversion (the latter not being a problem if you convert early in the year), because only one convert-undo cycle is allowed per year.

Disclaimers about the Advice Above.

  1. It is usually smart to use retirement money last, and keep in it investments that grow fast (stocks). If you hold in your IRA slow growing assets, such as bonds or cash, some of the considerations in favor of a conversion are moderated. This case is not addressed in this article, since it is typically not recommended.
  2. If the government decides to abolish the income taxes, replace them with a consumption tax, and leave the Traditional IRAs free and clear of taxes, a Roth IRA would be a much worse choice. It is doubtful that the government will give such a big gift to Traditional IRA owners, but it is a possibility.

Summary

Starting in 2010, all Americans have an opportunity to convert their entire IRA balances to Roth IRA. This article analyzed some of the considerations. While it may be difficult to make the best decision, in most cases it is well worth the effort. If you do not have a professional that can help you with this decision, in most cases a Roth IRA will be your better deal.

1 Investment taxes = Interest, dividends and capital gains

2 When estimating your future tax rate, take into account the investment taxes on your taxable portfolio + IRA amounts you convert or withdraw in that year. For example, a portfolio like Long-Term Component may generate 3%-4% taxable income each year. If you expect to have over $10M in such portfolio in a taxable account you are likely to stay at the highest tax bracket for life.

Disclosures Including Backtested Performance Data

The first thing you are likely to hear about Individual Retirement Arrangements (IRAs) is that they are: “tax deferred” accounts. Some may add that they provide: “compounded growth before being taxed”. This article refutes these claims and analyzes the actual tax benefits of IRAs:

  1. The ability to pay income taxes at a lower rate, if your income tax rate is lower at retirement.
  2. Money is investment-tax free (interest, dividends and capital gains), while in the IRA.

Identifying the actual tax benefits of IRAs is essential to decide between IRAs (called Traditional IRAs) and Roth IRAs. The decision between the two types of IRAs will be the topic of the next article.

What is an IRA?

Let’s start by defining an IRA: Individual Retirement Arrangement is a retirement plan account that provides some tax advantages for retirement savings in the United States. You can open such an account as a brokerage account, letting you invest in a similar way to other brokerage accounts. It has limitations on withdrawals, while providing tax benefits.

A Roth IRA, is an IRA that does not provide a deferral of income-taxes:

  • Any money put into the account is taxed like the rest of your income.
  • Any money taken out of the account is not taxed, like any other regular account.

Other differences between Traditional IRAs and Roth IRAs, as well as benefits specific to Roth IRAs, are left for discussion in the next article.

Potential Benefit: Tax Deferral

When putting money into an IRA, you can typically avoid paying income tax, letting the money grow for many years, until you withdraw the money. Let’s review the benefit of the tax deferral with an example. Note that this example is constructed to isolate the tax-deferral effect, leaving the other IRA benefits for a later discussion.

In this example a 50½ year-old person makes one $5,000 IRA contribution, and starting at age 70½ he starts making Required Minimum Distributions, until he dies at age 90½, and his heirs take out the full balance.

The first two years of withdrawals are detailed with 3 steps: (1) the account value before the withdrawal (reflects the investment growth), (2) the account value split to the amount to withdraw and the amount left, and (3) payment of income taxes on the amount withdrawn.

Later, two more summary lines are provided for 10 and 20 years into the withdrawal phase, followed by a full withdrawal by the heirs.

The Value of Tax Deferred Money
(Ignoring Tax-Free Gains, Income Tax Rate: 30%, Investment Growth: 17%)
Point in Time Traditional IRA Taxable Account
Income earned $5,000 $5,000
After putting into the account $5,000 $3,500 after income tax paid
Annual withdrawals at age 70½ Withdraw Left Withdraw Left
After 20 years of growth $115,528 $80,870
Before withdraw 1/27.4 of account $4,278 $111,249 $2,995 $77,874
After withdraw 1/27.4 of account $2,995 after tax $111,249 $2,995 $77,874
After 1 year of growth (age 71½) $130,161 $91,113
Before withdraw 1/26.5 of account $4,915 $125,320 $3,440 $87,724
After withdraw 1/26.5 of account $3,440 after tax $125,320 $3,440 $87,724
.        
+9 years (80½), withdraw 1/18.7 $13,356 after tax $337,714 $13,356 $236,400
+10 years (90½), withdraw 1/11.4 $52,673 after tax $782,563 $52,673 $547,794
Heirs withdraw balance $547,794 $0 $547,794 $0

In the example above, we can see that tax deferral is not a benefit of IRA accounts at all. This is apparent by seeing that all numbers under the “Withdraw” columns are equal at all times. No matter how long the money is in the account, what the income tax rate is (as long as it is the same when contributing to the account as when withdrawing from it), what the investment growth rate is, and how you withdraw the money (how often and which amounts), you end up with the exact same amount of money for use during retirement.

How is this possible? It stems from the simple mathematical law: the order of multiplication does not affect the result. Here are both calculations of the value of the accounts if withdrawn after 20 years:

Traditional IRA: $5,000 x 1.1720 x 0.7 = $80,870

Taxable: $5,000 x 0.7 x 1.1720 = $80,870

Note that after putting the money into the account, and up until right before withdrawing the money, the IRA balance is indeed greater. This may be the source of the error of seeing tax deferral as a benefit. This is an error because you cannot use the IRA money without paying income tax on it. So, you are only fooled to believe you have more money, until after paying the income taxes.

How is this information useful? Since income tax deferral provides no benefit in IRA accounts, the deferral of income tax of Traditional IRA vs. no income tax deferral for Roth IRAs is not a reason to prefer Traditional IRAs over Roth IRAs. Only Benefit #1 below provides a reason to prefer Traditional IRAs in some cases (when the benefit exists and outweighs the extra benefits of Roth IRAs, as will be discussed in a future article).

Benefit #1: The Ability to Pay Income Taxes at a Lower Rate

If your income tax rate declines in retirement, the deferral of income taxes does provide a benefit. For example, if your tax rate goes down from 30% to 20%, you get:

Traditional IRA: $5,000 x 1.1720 x 0.8 = $92,422

If we divide this calculation by the original one (30% tax rate), we get:

Benefit = ($5,000 x 1.1720 x 0.8) / ($5,000 x 1.1720 x 0.7) = 0.8 / 0.7 – 1 = 14.3%

The benefit depends only on two numbers: the tax rate when the money is put into the IRA vs. the tax rate when the money is taken out. It doesn’t matter how fast the account grows, and it doesn’t matter if the money is in the IRA for 1 year, 40 years, or any other number of years.

On the other hand, if your income tax rate is higher in retirement, the use of an IRA creates a penalty. For example, if your tax rate goes up from 30% to 40%, you returns decline by: 1 – 0.6 / 0.7 = 14.3%

Note that the exact benefit depends on the tax paid on the full amount, which may include paying parts of the tax at higher brackets. This information is very important when comparing to a Roth IRA.

If you expect your tax rate to be higher in retirement, you can convert your IRA to a Roth IRA, to make sure you pay taxes at today’s lower rate, while keeping the other IRA benefits and more benefits specific to the Roth IRA that will be covered in a future article.

Benefit #2: Investment-Tax Free

Any money put into an IRA, is free of investment taxes (interest, dividends and capital gains), for as long as the money is in the IRA. This provides a clear benefit that increases with the time the money is in the account. For example, say you are invested in a portfolio like Long-Term Component, and assume that the long-term growth is 17%, with 7% taxed each year, at a combined federal rate of 20% (mostly long-term gains and qualified dividends at 15%, and minimally short-term gains and non-qualified dividends), and state rate of about 10%. Your tax cost is 2.1% per year. The example above becomes:

Taxable: $5,000 x 1.1720 x 0.97920 x 0.7 = $52,898

If we divide the original calculation by this calculation one, we get:

Benefit = ($5,000 x 1.1720 x 0.7) / ($5,000 x 1.1720 x 0.98620 x 0.7) = 1 / 0.98620 => 53%

Summary

IRA accounts offer tax deferral of income taxes, which, contrary to common belief, is not a benefit. They do provide two other great benefits:

  1. The Ability to Pay Income Taxes at a Lower Rate: In case your income tax rate goes down by the time you withdraw your money, you get a benefit that depends on (and only on) the tax rate when withdrawing when compared to the tax rate when depositing the money in the first place.
  2. Money is Investment-Tax Free, while in the IRA: This is a substantial benefit that grows with the time the money is in the account, and grows with the investment taxes saved.
Disclosures Including Backtested Performance Data