Quarterly Newsletter
Summer, 2024
Tax & Investment Planning
Tax Deferral and Tax Exemption in the Context of IRAs
Most people understand the benefit of tax deferral and tax exemption, but it has a special meaning in the case of IRAs and Roth IRAs. For purposes of the following discussion assume the tax rate is 40%, that it never varies over time, that the nominal discount rate is the same whether assets are held in a taxable account, an IRA or a Roth IRA, and that there is no difference between the tax treatment of capital gains and ordinary income. Admittedly these are significant or even heroic assumptions, but one has to start somewhere.
The benefit of tax deferral (in general) is equal to the earnings on the amount of money the government would otherwise collect, multiplied by 1 minus the tax rate, or 60% in this example. It is as if a rich uncle allows you to use his capital (at no cost to you) for some number of years and only demands a certain percentage of the earnings. The government always and forever has a claim on the original deferral plus the earnings at a rate of 40%, but the amount to which the 40% is applied is much larger (and belongs to you) because the government has allowed you the use of the capital at no charge. This is the famous tax-deferred compounding that occurs within every IRA or qualified retirement plan.
In 1998 the government came up with a new deal, called the Roth IRA, which included an option of converting a regular IRA to a Roth IRA. A cynic might suggest this conversion option had something to do with ballooning federal deficits and a desperate need for cash.
Along the spectrum of fully taxable vs. IRA vs. Roth IRA, the net present value of the IRA or Roth IRA is more than the taxable option. In addition, the net present values of the IRA and Roth IRA are always equal (since the government always has a claim on the deferred tax), up to the point where required minimum distributions must start. From this point forward the Roth IRA is superior since the cash required to be withdrawn in the IRA option compounds at a taxable rate rather than a tax-free rate (assuming the funds are invested rather than used for consumption).
The bottom line is that, with certain simplifying assumptions, one can state that an IRA or Roth IRA is always preferable to a taxable investment and that a Roth is preferable to all other options, assuming the RMD point has been reached and funds are not otherwise withdrawn from the Roth.
A Sleeper Tax Shelter
A low-cost variable annuity remains a viable tax shelter hiding in plain view. Gains in the stock market have propelled some taxpayers into a position where they do not need taxable dividends, interest or capital gains to sustain a certain standard of living. For these lucky individuals, the earnings on their taxable portfolio serve no purpose other than to augment the coffers of the government.
A viable strategy in this situation is to consider buying a low-cost variable annuity with after-tax funds that do not have built-in gains (bonds, or stocks with little appreciation). Funds deposited in a variable annuity are exempt from required minimum distributions and earnings are fully tax-deferred. Furthermore, the funds inside the annuity can be accessed at any time, the only “penalty” being the income tax that must be paid on earnings within the account. The major difference between investments held in a taxable brokerage account and investments held inside a variable annuity is that in the latter case the investments are inside an insurance “wrapper”. While there are some additional restrictions and requirements for investing inside a variable annuity, in certain circumstances they are totally outweighed by the tax benefits.
Several investment companies offer such low-cost variable annuities, including Fidelity Investments, which offers such a product with no loads, no surrender charges and yearly fees of as low as 10 basis points (.10%).
We are happy to address any questions you may have about the above strategies. Feel free to contact us by telephone or email.