Tax-Deferred Investments
February 25th, 2007I’d like to point out a common misconception. We’ve all heard how smart tax-deferred investments are, like an IRA or 401k. The money builds up faster because the compounding takes place tax-deferred (or tax-free in some cases). Here is a common example used to compare taxable vs tax-deferred investments:
Looks pretty simple. Your money grows faster if you don’t have to pay taxes on it. Seems like common sense. But the truth is that this chart is 100% misleading and 100% inaccurate. If you understand the Rule of 72 and how money works, you understand that it takes time for your compounds to actually start to make a large difference. The chart above assumes that each year you take money out of the investment to pay for the taxes due, when in reality this does not happen. The above chart does not take into account the fact that your annual income taxes are filed together with everything else – your mortgage interest, deductions, income, etc… Your tax liability would have to be substantial before you would have the need to take money out of your investments in order to pay your tax liability.
Even then, would it make sense to do so? Maybe, maybe not. And, if you did not have any taxable mutual funds, and had a portfolio of stocks and ETFs, you would have zero tax liability until you begin to sell those positions. So, if you built your own diversified portfolio of stocks, you would never have any tax liability until you sold those positions, which is why a well diversified stock portfolio is a good long-term investment strategy – without the limitations of tax-advantaged investments such as IRAs and 401k plans.In addition, you could sell your stock positions which have a loss in December of each year and realize the tax-deductions you will receive from the loss – then reacquire the positions in January again. To me, this is a better alternative than tying all of your money up in retirement plans. In addition, you could add some high-yield guaranteed savings account savings to your portfolio.
These days, you can get 4.75% and higher in “eSavings” accounts like Citibank Direct, ING Direct, MetLife, CapitolOne and more. I have added a Citibank Direct eSavings account to my portfolio, which is FDIC insured and pays a current rate of 4.75% APY. Check out BankRate.com for a list of all of these high-yield savings accounts.I am not saying that mutual funds are bad. In fact, you should have them as a part of your total diversified portfolio. Nor am I saying that you should not have IRAs or 401ks. Just try to understand the big picture and don’t buy all of the propaganda that financial planners, insurance agents and magazines feed to you. Next time you are told by a financial planner or insurance agent that you need to have an IRA (yes, even a ROTH IRA), print out this blog and bring it with you. In summary, I think that your portfolio should consist of the following, in this order:
- Non-Retirement “Emergency Fund”. 6-12 months take-home pay in the bank. This money is not meant to grow or make you rich. It is the base of your financial stability.
- Non-Retirement stocks (follow the strategy I explained above)
- Non-Retirement mutual funds
- Non-Retirement High-Yield savings account
- 401k only up to the amount your employer matches.
- Roth IRA or Traditional IRA – fill it up with mutual funds! The type really depends on your current tax situation. A Roth IRA is not a one-size-fits-all product. If using a traditional IRA can lower your tax bracket for the year, it should be selected instead. This could save you thousands of dollars for the year. Consult an accountant (not a financial planner or insurance agent) to determine which option is best for you.
- Variable-Universal Life Insurance (Option B and over-funded only) and/or additional 401k contributions.
I would stay away from:
- Corporate bonds. (Corporate bond mutual funds and municipal mutual funds are OK)
- Annuities of any kind. Especially qualified annuities.
- Whole life or universal life for savings purposes. There are situations where these products make sense (estate planning, guaranteed issue due to health, etc…), but these are not good savings vehicles at all for anyone ever.
- CDs. You’re better off in an eSavings account with no restrictions.
UPDATE - Here is some additional information on some of the things you should be aware of when using a stock buying/selling strategy as I have described:
Traditional IRAs vs. Roth IRAs Article 1 Article 2 (Remember, it’s not good enough to look at the “end result”. You need to consider your actual tax situation, which may require the professional assistance of an accountant.)
Alternative Minimum TaxThis blog is not intended to be an all-inclusive “how-to” guide – however it does raise serious questions about what we are told is the right way to invest for retirement. It is also noteworthy that if a person is not a disciplined, active investor, then such methods may not be the best if managed personally. A qualified accountant and financial planner who share your same vision is highly recommended. Keep in mind, though, that my ideas here are not the traditional common viewpoints of most. You will more than likely experience some resistance and adversity with these ideas. Remember – if you do what everybody else does, you will more than likely wind up like everybody else.
Not that I disagree with your advice in general, but there are a few points I wanted to address. I think this point is a little misleading: “if you built your own diversified portfolio of stocks, you would never have any tax liability until you sold those positions, which is why a well diversified stock portfolio is a good long-term investment strategy – without the limitations of tax-advantaged investments such as IRAs and 401k plans.” I say misleading because it’s a blanket statement that fails to take into account the investment goals, investment skill, and risk tolerance of an individual investor. One problem with a stock portfolio is that all of the commissions add up — you don’t mention DRiPs, which is probably the best way to make a long-term investment in stocks for this reason. Later you talk about using stock market losses to offset gains, but then you have to be careful to avoid a “wash” sale, and have to be rigorous in lot-based recordkeeping of your stock purchases.
Another problem with that strategy is that stock losses can only offset stock gains — so if you don’t have any gains, or if you have more losses than gains, you aren’t going to get maximum value out of this strategy. With stocks you also have to be concerned with long term versus short term gains, since short term gains are much more costly at tax time. Finally, consider the problem of the AMT (alternative minimum tax). Anyone who is having a lot of stock market gains (particularly if they come from options) and who simultaneously has a lot of deductions could easily fall afoul of the AMT — even at relatively modest AGI (adjusted gross income) levels. If you do run into AMT, your strategy of using other forms of deductions to offset the higher taxes of short term capital gains is going to fall on its face. I don’t mean to pick apart your post — because there is a lot of good advice there too — but just to throw out some additional cautions about stock market investing. In my experience, the people will always tell you when they do well in the stock market but are silent when they take a beating. Stocks are an important part of any successful long term investment strategy, but they have pitfalls that can trip up the unwary investor.
One last nitpick- I think you are a little to harsh against CDs. Many high yield CDs aren’t as restrictive as you might think. For example, there are CDs out there with supposedly 5 yr terms which compound interest monthly and for which the only penalty for early withdrawal is a 7-day hold and 3-6mo. of interest. Right now savings yields are not much worse than even 5 year CDs, but when there is more of a gap you are better off putting your money in a CD because the higher yielding CD’s rate compared to the savings rate will more than offset any penalty you might pay for withdrawal (in effect making the CD as liquid as a savings account).
I just wanted to add that the safest, most effective strategy for long term gains is to sign up for a bunch of credit cards, take high interest balance transfers, and do margin investing, short sells, option speculation, and after-hours trading. Few savvy investors who haven’t succeeded with this method.
Good post. You make some good points. There certainly are other angles to consider (Wash sale, AMT, etc…), all out of scope of a single blog entry. And to add to my post… This approach is for the more financially saavy investor who can take the time to research, understand and investigate these methods. I do want to reiterate that the charts and hypothetical illustrations used to compare a fully taxable VS. tax-deferred investment are 100% totally misleading.
But it’s sad fact that many still prefer to “play safe” and go into annuities, CD and keeping money in saving accounts. These are people who are afraid of losing money, without realizing that they can never build up their wealth in this way.
I just wanted to reply to Bernard’s comment. Investing ONLY on the risk-free and low-risk investments is a painfully slow way to grow wealth; but the riskier options may not be appropriate given someone’s investment goals and risk profile. For someone about to retire, the risk-free options may indeed have more merit.
Personally, I think stock speculation is a loser’s game. For every person who crows about making a killing, there are thousands if not tens of thousands of people who lost their shirt. I am convinced that steady investments in solid companies, over time, will yield better returns overall for the average investor. For most people, a diversified portfolio of solid companies (particularly those paying dividends) will pay off handsomely in the end. Of course, if you really are a hotshot, maybe you can do better with daytrading.