Favorable capital gains tax treatment (and statistics) provide a better investment vehicle than IRAs

The tax code offers a number of options to allow people to invest for retirement in ways that get friendly tax treatment. Individual Retirement Accounts (IRAs) and 401(k) plans are just a couple of the more common options, although there are many more. Unfortunately, these accounts come with a lot of restrictions and can sometimes cause severe penalties. And in most of these accounts, you’re not getting any special break on your tax rates, just a deferral on when you recognize the income. Plus many people aren’t able to participate at all due to high income.

Wouldn’t it be nice if the IRS allowed retirement savings options where you could get current year deductions, withdraw your money at any time without penalty, and then get favorable tax rates when you retire?

Well believe it or not, the tax code allows you to do just that. I’m not talking about a specific code section or any type of “plan” with a specific name. What I’m talking about is the rules for tax treatment of capital gains and losses.

You see, the tax code has numerous provisions to protect wealth. (You may have heard that it’s the other way around, but I won’t get into the politics of why that’s such a popular misconception.) One of the most important provisions is the treatment of gains on losses from capital investments. If you invest in stock or land or any of the numerous other categories of capital investments, you get different tax treatment depending on whether your bet is a “winner” or a “loser”.

If your asset goes down in value–it’s a loser–you can sell the asset and reduce your “ordinary income.” Ordinary income is basically all income other than capital gains and losses…and it all gets taxed at marginal rates that can go up to 35%. So if you lose money, you actually lose as little as 65 cents on the dollar, depending on your tax bracket. But if your asset goes up in value, and you hold it more than a year, then when you sell the asset you get taxed at a maximum rate of only 15%. So when you win, you win 85 cents, when you lose, you lose only 65 cents. (You won’t find those odds at any table in Vegas!) No matter what your tax bracket is, the tax you pay on the gain from these capital assets will be less than your tax on any other type of income (except qualified dividends, but I’m trying not to get too technical here).

This preferred treatment of capital gains has existed for almost the entire period since 1954. One could argue this has been a significant factor in the long-term run up of stock prices in the US. (For the rest of this article, whenever I refer to stock, I could mean any other capital asset. Stocks are just the most common example.) And this treatment, combined with the laws of probability, give rise to a way to save for retirement that in many ways makes better sense from a tax perspective than any of the traditional types of retirement accounts.

The approach is relatively simple, but first a quick look at the conventional approach. Let’s say you’re around 30, currently saving $5,000/yr for retirement, and plan to continue to do so for the next 20 years. The conventional wisdom would say a simple, tax-efficient approach is to put this money into an IRA and invest it in a low-fee mutual fund or ETF that provides broad coverage of the stock market. While that’s not a bad approach, here’s something not much more complicated and considerably more tax-efficient: Open an account with a discount broker and buy a dartboard.

OK, the dartboard is figurative. Countless studies have shown that mutual funds and similar instruments consistently under-perform the market. The reason is simple–annual fees, even low annual fees of 0.5% of your account value, will significantly erode the value of your account over time. An individual investor picking stocks at random and buying them for $5-10 per trade will get better results on average than the mutual fund because the trading fees plus the cost of a dart board are significantly less expensive than the fees charged by money managers, and a large basket of stocks will perform the same whether picked at random or by a “professional” money manager. Countless studies have verified that money managers do no better than what would be predicted by random selection of stocks, just google it.

Alright, so I’ve just explained why you’re probably better off letting your dog pick stocks than paying a “professional,” but what does this have to do with taxes? Well here’s where the strategy comes in. Let’s say instead of putting $5000 into an IRA every year, you select 5 stocks at random and buy $1,000 worth of each stock. If you start this early in the first year, you might have some “losers” by the end of the first year, which you can sell by year-end and take a tax deduction. Over time, you’ll probably have numerous losers, which can be sold anytime you want to take a tax deduction to reduce your taxable income. Of course, you’ll also accrue winners, and these are the stocks you hang onto for retirement. When you’re ready to sell those, you’ll get reduced tax rates on the gain–something you won’t get on distributions from any retirement account that’s not a Roth. And at any point in your life, if you need to access your “retirement account”, you’re free to do so with no penalty. In fact, as long as you’ve held the stock more than a year, when you cash it in you’ll get favorable tax rates.

So there you have it–current deductions, penalty-free withdrawals, and favorable tax rates in retirement.

Now, to address a few criticisms that I’m sure some people might have.

Those who are very familiar with retirement accounts might point out a Roth is similar with less complexity. You pay no tax on the gains in a Roth, which is a better deal than even the capital gains rates. And you’re able to take a limited amount of penalty-free withdrawals. And though there’s no current deductions with a Roth, the current deductions under this approach are limited to $3,000 each year and will probably be less than that most years. Fair enough. If you have no interest in current deductions, AND your income is below the Roth limit (currently around $100k), then the Roth is probably a better option if you’re willing to accept the restrictions on Roth plans. But if your income is above the limit, or you just like the freedom of being able to access all of your money at any time without penalty, this approach offers some advantages over a Roth.

I’m sure some people also can’t imagine leaving their retirement savings to random chance. But realistically, that’s what we all do all the time. Nobody knows where any asset’s price is going to go, and the “professional” money managers have consistently demonstrated they’re no better than average…they just charge you for the privilege of mediocrity. As long as you’re committed to buying a large basket of stocks…like 100 or more…the odds of your random basket performing significantly different than the market average drop pretty close to zero. The more stocks you buy, the better your odds of this random sampling matching actual market returns. Of course, the more you buy, the more trading fees you pay. But even if you buy in lots of only $100 each and pay a $5 per trade fee, your costs over ten years would be less than the fees of a money manager charging 0.5% annually. And if you’re only buying stock $100 at a time, you can diversify a LOT.

Finally, there’s the problem of the tax code always changing. While it’s certainly true that the tax code will change significantly over the next few decades, it seems reasonable to assume that favorable treatment for capital gains will remain a feature of the tax code. This has existed for all but a couple of the last 55+ years. And given the reality of politics, does it seem likely to you that a tax break that favors the incredibly wealthy will go away? My opinion is it’s very unlikely, but you’ll have to consult your own crystal ball on that one.

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