It pays to delay.
The longer you postpone the taxes on your investment gains, the bigger your portfolio is likely to get. The payoff can be enormous.
Many folks get tax-deferred growth through retirement accounts, like 401(k) plans and individual retirement accounts. But you also can fend off the tax man by buying variable annuities, purchasing cash-value life insurance, or simply buying and holding stocks in a taxable account, which delays the capital-gains tax until you sell.
The problem is, these strategies sometimes come with a steep price tag, including both hefty investment costs along the way and punishing tax treatment when you cash out.
For instance, even if your variable annuity, 401(k) or IRA earns impressive capital gains, the gains get taxed as ordinary income when the money is withdrawn. That's bad news for those in higher tax brackets, because their capital gains get taxed at no more than 28 percent, while Uncle Sam can dun income for as much as 39.6 percent. This disadvantage will be even greater if the capital-gains rate gets cut.
Moreover, with retirement accounts, you could get slapped with a 10 percent tax penalty if you pull money out before age 59.5, and your estate could get hit with a 15 percent excise tax if you die with a large amount in your account.
Variable annuities, which are mutual funds in a tax-deferred wrapper, avoid the 15 percent excise tax. Meanwhile, cash-value life insurance, which combines life insurance with an investment account, can sidestep both the excise tax and the 10 percent penalty. But Glenn Daily, a New York fee-only insurance consultant, says variable annuities and life insurance have a different problem: They're often inordinately expensive, thanks in part to sales commissions.
But is the price of tax deferral too steep? It depends. Let's say you put $2,000 in a taxable account, which then grows 10 percent a year. Each year, the full 10 percent investment gain gets taxed at 28 percent, which you pay by dipping into the account. Result? After 25 years, you have some $11,374.
Now imagine that instead you make a $2,000 non-deductible contribution to an IRA, which also gains 10 percent a year. After 25 years, you pull the money out and pay a massive tax bill on a quarter century of tax-deferred growth. But even after handing over 28 percent to Uncle Sam, you're left with $16,162, or some 42 percent more than with the taxable account.
A fair comparison? It's easy to quibble. You might, for instance, incur the 10 percent penalty on your IRA withdrawal.
"A lot of times, people will incur that 10 percent penalty when they're facing rough economic circumstances," notes David Polstra, a financial planner in Atlanta. "They don't have a lot of income, so they're only in the 15 percent tax bracket. Add in the 10 percent penalty and they're only paying 25 percent."
On the other hand, when you tap your IRA, you might have a lot of investment income bunched in a single year, which pushes you into a higher tax bracket. But even if you got hit after 25 years with both the 39.6 percent tax rate and a 10 percent tax penalty, you would be left with $11,913, or 5 percent more than with the taxable account.
I'm not suggesting that the IRA is always a better bet or that you should yank money out of retirement accounts, oblivious to the 10 percent penalty. But there's an important lesson here: It's not how much you pay in taxes that matters. What counts is how much is left after Uncle Sam gets his due.
The fact is, given enough time and enough tax-deferred compounding, it's possible to overcome the burden of both high investment costs and unfavorable tax treatment. Your best bet, however, is to minimize these burdens at the outset, by sticking with your most attractive options.
"The first place you should go is your employer's retirement plan," says John Cammack, a financial planner with Baltimore's T. Rowe Price Associates.
With it, you may get the triple bonanza of an initial tax deduction, continuing tax-deferred growth and a matching contribution from your employer, who might throw in 50 cents or more for every $1 you invest.
Even if there's no employer match, I would still make full use of any tax-deductible retirement accounts, whether it's your employer's plan or a tax-deductible IRA.
If you have additional money to save, where should you turn next? Financial advisers often make a pitch for variable annuities, cash-value life insurance or non-deductible IRAs.
For many investors, however, I reckon the best bet is to buy and hold stocks in a taxable account. That way, you don't incur hefty investment costs and your capital gains won't get taxed as ordinary income.
Peggy Ruhlin, a financial planner in Columbus, Ohio, touts Berkshire Hathaway's stock. It never generates an annual tax bill because the company doesn't pay a dividend.
_ Jonathan Clements writes for the Wall Street Journal.