Quarterly Newsletter

Winter, 2022

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 From this point forward the Roth IRA is superior since the cash required to be withdrawn in the IRA option compounds at a taxable rate rather than a tax-free rate (assuming the funds are invested rather than used for consumption).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and that a Roth is preferable to all other options, assuming the RMD point has been reached and funds are not otherwise withdrawn from the Roth.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.

Tax Shelter

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%).


Cash is Trash?

It is common in the popular financial press to hear the view expressed that “cash is trash”. This is particularly so with the recent spike in inflation and inflation expectations. But this view is not uniform.

The most famous adherent to this view is Ray Dalio, CEO of Bridgewater Associates, the largest hedge fund in the world. A corollary of this would no doubt be “don’t try to time the market”. Certainly under current market conditions, in which short-term investments earn nothing, a large cash holding is tantamount to saying that other investments are overvalued. Therefore Mr. Dalio must believe there are still attractive risk-adjusted returns to be had.

The opposite view is expressed by Dan Niles, another hedge fund manager and founder of the Satori Fund. He recently stated that cash is his best idea right now, given the overvaluation of many other parts of the market (particularly high-tech).

So this comes down to a question of whether investments other than cash are grossly overvalued, and whether it makes sense to act upon this view. Ray Dalio presumably would say that there remain enough investments with projected returns greater than cash, and providing some protection against inflation, that one should minimize cash holdings. Dan Niles would presumably say that the universe of potential investments is grossly overvalued and that there is not enough potential return to outweigh a decision to hold a significant amount of cash.

The entire complex of fixed-income investments has negative real yields (in the case of treasuries) or negative risk-adjusted real yields (in the case of high-yield bonds). Duration is one measure of the loss that will ensue with an increase in interest rates. Roughly speaking, a duration of 10 means that a bond will lose 10% of its value for every 1% rise in interest rates. With this degree of risk one might conclude that cash offers a better risk-adjusted projected return, notwithstanding near-zero yield.

The same might also be said of sectors or parts of the market, such as high-tech. Many companies in this space have no earnings and are selling at many times sales, rather than earnings. One could rationally conclude that cash offers a better projected return. On the other hand there are many stocks that are selling at multiples of earnings that are very reasonable by historical standards, and in addition offer high current dividends.

So in the final analysis it can be a rational response to hold a significant amount of cash. But the opportunity cost can be high and the odds can be long, since you have to be correct about many other sectors of the market.


2021-2022 Tax Law Changes

None of the tax changes that so many pundits had been predicting came to fruition in 2022, mainly because the Build Back Better Bill, which contained all these provisions, is still languishing in Congress and the odds of its passage are low. Had that bill passed there would have been very significant changes in estate and income taxes. Following is a list of notable changes for 2021(already part of the law):

We are happy to address any questions you may have about the above strategies. Feel free to contact us by telephone or email.