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Monday, February 28, 2005

Are Roth IRAs bad public policy? (Or the difference between theory and reality) 
A new blog, Borrow a Trillion Dollars, makes the case here in a series of lengthy posts.

One of his arguments is that the tax-free growth of Roth IRAs simply don't deliver anything more than marginal benefits over a Traditional IRA or taxable account.

I will argue that his premises are flawed, because the substance of his post lies in two key assumptions:

1.) All investments are perfectly tax efficient.

Which means

A.) no company ever issues a dividend (taxable),

B.) no bond ever generates income (taxable, unless you assume that all bonds are zero coupons maturing at retirement, but even then, the imputed interest on zeros are taxable anyway

C.) No mutual fund ever sells anything, realizing capital gains, no matter what.


and 2.) Nobody ever rebalances between these mythical perfectly tax-efficient investments. When you rebalance, you have to sell off some of your winners and buy some of your losers. You can offset capital gains on your winners with losses to some extent, but only to the tune of a few thousand dollars per year. As portfolios grow, there could never be enough deductible losses to meaningfully offset gains.

But because even stocks, as a whole, generate dividend income, which would be taxable outside of an IRA or qualified employer plan (even the S&P 500 issues a dividend of about 1.87%, and other asset classes significantly more than that), tax-advantaged accounts retain much of their allure, even if marginal tax rates remain constant into retirement.

Furthermore, he argues that 401(k)s and traditional IRAs are treated equally for tax purposes. But that's simply wrong, for estate planning purposes, because of the way most 401(k) plan rules work. Here's why:

If the account holder dies, most 401(k) plans require heirs to take all distributions within five years, regardless of tax consequences. The result is the loss of a lifetime of tax-free compounding. To make matters worse, a large 401(k) balance withdrawn within five years -- all taxable as income, can in and of itself drive the beneficiary into a higher tax bracket, while disqualifying them for needed tax breaks, tax credits, need-based financial aid, etc., etc.

An IRA, on the other hand, can be distributed over the beneficiary's entire lifetime. The result is often decades of tax-free (Roth) or tax-deferred (traditional) growth, with all rebalancing and trading activity free of capital gains taxes. (Had the balance been in a taxable account, all rebalancing and trading activity would have generated at least 15% in capital gains taxes, minus up to a few thousand dollars per year in offsetting losses (IF AVAILABLE).

Third, the differences in the way these plans are taxed creates certain planning opportunities for a savvy advisor:

Divide assets into four quadrants: High return/High tax-efficiency, low-return/high tax efficiency, high return/low tax efficiency, and low return/low tax efficiency.

From there, you prioritize which investments should go into your IRAs first (called solving the asset location problem).

For example, high-return and low tax-efficiency asset classes, such as REITs, do significantly better inside IRAs than outside of them, even considering that assets outside the IRA will eventually be taxed at capital gains rates, rather than as income.

High return and high tax-efficient vehicles (i.e., large cap growth stocks with low or no dividends) do much better OUTSIDE of the IRA: they generate little in the way of taxable dividends and any sales are taxed at capital gains rates.

Low return and low tax-efficiency vehicles should go into the IRAs next, until you run out of room, after all high return/low tax-efficiency assets have gone in. But don't sweat it...the difference between the two locations is small, assuming you don't trade too much.

Low return and high tax-efficiency assets should go in last, if at all. You may wish to preserve liquidity in these assets anyway, and you don't have to worry about any 10% penalties for withdrawals before age 59 1/2.

Another aspect of planning this guy misses is the benefit of diversification against tax risk. With assets in a variety of vehicles, the investor is not overly exposed to any major changes in tax law.

For example, if everything he had were held in a Roth IRA, he is dependent on a promise that Roth IRA withdrawals will forever be tax free: a Congressional promise that could be broken anytime. This is a particularly important factor for those in higher tax brackets, who will of course, be the targets of any "soak the rich" tax hikes in the future. Remember that marginal income tax rates once reached 90%.

They could do so again.

Anyone with everything he has in a Roth IRA could be devastated by such a move.

By spreading his assets out among a variety of tax structures, an investor can effectively hedge against the risk of a disadvantageous tax law change in the future.

So while this blogger's ideas aren't far off the mark in theory, in practice, they don't hold up to scrutiny.

Splash, out

Jason

UPDATE: For everything you ever wanted to know about determining optimal asset locations, click here.

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