A taxable account can outperform an IRA

20% capital gains rate means less to IRS after your growth stock zooms

Nest-egg strategies

Dollars & Sense

January 09, 2000|By Jeff Brown | Jeff Brown,KNIGHT RIDDER/TRIBUNE

Many investors share a hope: that Washington will someday allow them to put unlimited sums into tax-favored accounts. But for now, they are stuck with rules that limit annual contributions to $2,000 for IRAs and $10,000 for 401 (k)s.

If only more could be put in! Imagine the gains that would be realized with no tax on profits for decade upon decade.

Actually, you can do just as well in an ordinary, taxable account if you manage things right. In fact, you could do "better" in a taxable account, according to a study by PricewaterhouseCoopers LLP.

That's because some of the tax-deferred accounts come with strings attached. There may be an upfront tax savings on money put into the accounts, and there's no annual tax on investment profits, interest earnings or dividends. In most cases, when you make withdrawals in retirement, you have to pay income tax on profits and on money that wasn't taxed before it was invested. Income tax rates for most investors are 28 percent to 39.6 percent.

Contrast that with a taxable investment account -- one where there is no deduction for your contributions. But profits on investments held longer than one year are taxed at a maximum capital gains rate of 20 percent, half the top income tax rate.

So which is better, tax deferral with a high income tax at the end, or no tax deferral and a lower capital gains rate?

The study compared the long-term, after-tax performance of identical portfolios, one in a tax-deferred account such as a 401(k), the other in a taxable account. It assumed an annual pre-tax return of 10 percent and an income tax bracket of 39.6 percent.

It determined how long it would take for the advantages of tax deferral in one account to outweigh the benefits of the low capital gains rate in the other. (Gains tax is paid only after an investment is sold.)

If all of the investments were in growth stocks that were simply held indefinitely, it would take more than 50 years for the tax-deferred account to reach a larger, after-tax level than the taxable account.

That's because there would be little or no annual tax in the taxable account, causing it to act like a tax-deferred account -- but one with a low 20 percent tax rate on withdrawals instead of 39.6 percent.

Obviously, it's harder for this account to stay ahead if some investments are changed each year in the taxable account, triggering capital gains tax. In the tax-deferred account, there is no annual tax even if investments are sold each year at a profit.

But the study found that, even if 100 percent of the taxable account's profits were subject to gains tax each year, it still would take more than 24 years for the tax-deferred account to overtake it on an after-tax basis. That's because the profits in the tax-deferred account would be taxed upon withdrawal at the sky-high rate of 39.6 percent.

The relative advantage bestowed by the low gains rate in the taxable account deteriorates if a larger portion of the account is devoted to "fixed-income" investments such as bonds. Dividends, bond coupons and interest on such other investments as money market funds are taxed at high income tax rates rather than low capital gains rates.

If the portfolio were made up of 40 percent growth stocks and 60 percent fixed-income investments and simply left untouched, it would take about 11 years for the tax-deferred account to beat the taxable account on an after-tax basis. That would fall to nine years if investment changes made all of the profits in the taxable account subject to capital gains tax every year.

Of course, the study represents extreme cases, minimizing the benefits of tax-deferral by using the top, 39.6 percent income tax bracket. That bracket applies to people with taxable incomes of more than $283,150.

For people in lower income tax brackets of, say, 28, 31 or 36 percent, the break-even periods in the examples above would be shorter, because the tax bite in the tax-deferred accounts would be smaller.

Still, the study show shows that with smart investing you can get the benefits of tax-deferral in a taxable account. (Moreover, in a taxable account you have no annual limits on contributions and can take money out without the penalties charged for early withdrawals in tax-deferred accounts.)

To get the biggest benefits, the taxable accounts should be packed with investments such as growth stocks that don't incur annual income taxes and can be held for the long term, allowing the investor to delay capital gains tax.

The tax-deferred account pays off best with investments that otherwise would trigger big annual tax bills at high income-tax rates -- bonds, dividend-paying stocks or mutual funds that make large annual dividend and capital gains distributions.

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