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"An Alternate Idea"

by Greg Mermel

Published in the "Money and Taxes" column in PerformInk on February 1, 2008

Two weeks ago, I threw out the seemingly radical notion that sometimes you are better off not using a tax-advantaged investment account (such as an IRA or 401k) to accumulate assets for retirement.

Neither the Inquisition nor the Taliban has dragged me away for that heresy, so here goes.

Changing from Unusual to Ordinary

The earnings from Roth IRAs are not taxed at all, provided you meet some fairly minimal rules about how long you have held the account. When you take money out of any other kind of tax-advantaged retirement account, however, the amount withdrawn becomes taxable income.

Specifically, it is taxed as ordinary income which (atypically for a tax term) is just what the name implies. Ordinary income includes wages, dividends and interest, business profits, rents, and just about any other typical bit of income save one: capital gains.

Capital gains occur when you have owned an asset for more than a year and sell it at a profit. Stocks, bonds, mutual funds and real estate are the most common examples, though the idea is much broader. Selling your car could produce capital gains, should it miraculously turn out to be a valuable collector’s item instead of a rusty piece of junk. Those lucky folks on “Antiques Roadshow” have capital gains when they sell those five dollar flea-market finds for tens of thousands of dollars.

What is important in this context is that capital gains are taxed at a significantly lower rate than ordinary income, not more than 15 percent compared with a maximum ordinary tax rate of 35 percent. But if that asset sale occurs inside an IRA, 401k, etc., the profit loses its character as a capital gain and becomes ordinary income when distributed to you. Tax-advantaged, in this case, equals more tax, not less.

In the real world, things are not as simple as they are in a columnist’s example. A mutual fund, for example, generates ordinary income (dividends) each year, and capital gains (we hope) when it is sold. Paying higher taxes later can sometimes be a better deal than paying lower taxes now, if enough time passes. And there is always the imponderable factor of future, not-yet-passed changes in tax rates.

Do It Here, Not There

You might also want to invest in things prohibited in a tax-advantaged retirement account. Not the nutty ones, of course, like llamas or Beanie Babies.

I’m thinking real estate.

Not necessarily rental property, since I recognize not everyone is cut out to be a landlord. But think also about your own home. For many years, that has been the single most valuable asset Americans accumulate before retirement.

That history is somewhat obscured by the present sturm und drang about falling property values and the meltdown of sub-prime lending. But I think those are relatively short-term situations. Real estate is inherently a long-term investment, and any long-term investment requires the patience to ride out ups and downs.

(A cautionary side note: what I said about real estate in the preceding paragraphs is a statistical approach, that is, something which is true on average. Any given piece of property might have results near the average, far better or far worse. Just as with financial investments, you need to evaluate both the broad category of investment and the particular asset. Professional driver on a closed course. Your mileage may vary.)

Non-Mathematical Decision Making

Sometimes the decision about tax-advantaged versus taxable investment accounts is made for you: if you are not eligible for a tax-advantaged account, you have no choice. But given an actual choice, few people make their decision on a purely rational basis.

That’s OK. What it really means is that you assign a value to factors that cannot be mathematically quantified.

Ease, for example. This is not a good factor in my view, because it is a polite way of saying, “I don’t want to think about this.” All too often, taking the least effortful course results in no savings at all. Many companies now acknowledge this and automatically enroll new hires in the 401k plan. This makes it easier to participate in the 401k than to not participate.

Better psychological factors involve financial discipline. Many people feel they would just spend the money if it were in an ordinary investment account. For them, money in a tax-advantaged account feels unavailable for spending due to the tax penalty for early withdrawal and the rigmarole involved in taking money out.

Others feel just the opposite. They need to have “mad money,” funds they can easily get to in an emergency – no matter how unlikely that is.

Both are correct, based on their own values.

The dollar limit on annual contributions to an IRA or 401k also cuts both ways as a psychological factor. For some, it is a chafing restraint; they see going beyond that as a challenge to prove their worthiness. For others, it can be a limiting goal: once they reach that, they have no further target and slack off.

Last in my list is the factor I think most important in this or any other investment decision: you have to do what lets you sleep at night.

Keeping Your Balance

In the end, most people wind up with a blend. By retirement, they have a home, an IRA, a taxable brokerage account and money in the bank. Find your balance, and stick to it.

Free Offer

Every year during the income tax season, I offer free copies of my “Checklist of Potential Deductions...” for those in the arts. Just call my office, or send an email to checklist@gregmermel.com.

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