A Tax Preferred Advantage Globally
The first goal of this book is to clarify that the role of deferred compensation is the best investment strategy for you to win the money game in your retirement plan even when subject to full ordinary income tax rates upon withdrawal.
Erroneous under standard assumptions
- It is sometimes said that capital gain property will suffer a tax disadvantage if placed in a tax deferred retirement account because the gain will be subject to full ordinary rates on withdrawal.
- Possible Confusions
The key role of the tax exemption is not always appreciated, as illustrated by statements that tax-advantaged investments, such as those producing capital gains, should not be placed in tax deferred retirement accounts because they will be subject to full ordinary rates on withdrawal. There is an error in the presumption that taxable bonds have a preferred location in a tax-deferred account, tax-exempt bonds have a preferred location in a taxable account, tax-efficient stock portfolios (e.g. passively-managed mutual funds) should be held in a taxable account, and tax-inefficient stock portfolios (e.g. actively-managed mutual funds) should be held in a tax-deferred account.
However, make it clear that tax deferred accounts can be advantageous even for tax-preferred investments if those investments would be taxed at a rate higher than zero outside a tax deferred account. Concluding that capital gain assets should not be placed in tax deferred accounts because they will be subject to ordinary income taxation on withdrawal is erroneous because it fails to take into account the tax benefit of excluding (at ordinary income rates) contributions to such accounts. Assuming that the applicable tax rate does not change, that benefit will be equal in present value to the burden of ordinary income taxation on withdrawal.
Although the conclusion that there is no tax advantage (or even a disadvantage) from placing tax-preferred assets in a tax deferred income account is mistaken, the relative advantage of exemption of investment income does depend on how the income would be treated outside such accounts.
Reducing the tax burden to zero on ordinary income taxed at, say, 35 percent is obviously a greater advantage than reducing to zero the burden on capital gains taxed at, say, 15 percent. These relative advantages are important when limitations preclude placing all of a taxpayer's investment assets in tax exempt contribution accounts. The resulting tax "pecking order" for assets to be held in qualified accounts is often violated by investors, who may, of course, be subject to other constraints.
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