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View Diary: The oft-repeated lie about the capital gains tx preference (74 comments)

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  •  this is not true! (6+ / 0-)
    Recommended by:
    ozsea1, VTCC73, Miggles, cosette, bear83, elginblt

    " they can lose nearly twice as much to taxes as they would if they left the money in ordinary (non-tax-deferred) brokerage accounts."

    Not true.  Non-tax-deferred accounts are based on money that has already had ordinary income tax paid on it. So if you put $1000 into an IRA, and your tax rate is 20%, the same money invested in a non-tax-deferred account would be an initial capital of $800. So the capital gains and dividend in future years would be be lower by 20%. then when you take it out, the gains are taxed again, even though the gains are already reduced because of the tax on the original investment.

    On the other hand, the IRA or 403(b) pays ordinary income tax only once. Even if that tax is 20%, you are ALWAYS ahead.

    Moreover, when you are retired your marginal tax rate may be lower, but that is a different point.

    •  I should add... (1+ / 0-)
      Recommended by:
      ManhattanMan

      ..that the conservative argument for reducing taxes on capital gains is that if one is investing money that has had taxes paid on it, then the investment income from it is also permanently reduced since the principal is reduced. In that sense the gains have "already been taxed".

      I do not agree that investment income should not be taxed, but it is important to understand the argument.

    •  Agree. The initial tax on income is like the (2+ / 0-)
      Recommended by:
      Nowhere Man, elginblt

      effect of a mutual fund with a high load at the front end.  It reduces the amount of principle on which you can earn dividends and then each dividend is taxed as well.  I did a quick back of the envelope calculation, and the difference is about 1% of gains per year with the tax deferred account winning out by larger and larger margins as the time frame increases due to compounding.  That gain difference will vary depending on chosen tax rates, etc, but I was more interested in getting a ballpark feeling for the effect.

      •  This is true (2+ / 0-)
        Recommended by:
        Miggles, bear83

        and I think your math is in the right ballpark. The problem here (which I perhaps should have spelled out more clearly) is that not everyone has an indefinite timeline.

        I started investing in a 401k almost as soon as I got out of college, in the mid-80s. I was in my 20s then, and the tax advantage of a 401k was clear to me. I'm now in my 50s. But if tax rates on dividends and capital gains continue to be kept low, or are further reduced, then there may come a time when I'd be better off making my investments outside of a tax-deferred IRA.

        Let us all have the strength to see the humanity in our enemies, and the courage to let them see the humanity in ourselves.

        by Nowhere Man on Sun Dec 02, 2012 at 05:41:02 PM PST

        [ Parent ]

        •  Yeah, I haven't taken a look to see where (1+ / 0-)
          Recommended by:
          Nowhere Man

          such a break-even point would be.  In my case, the main reason I do the 401k is because my employer matches contributions that I make.  Otherwise, I'd be willing to take the tax hit early and have the funds in a taxable brokerage account that is 100% under my control without early withdrawal penalties.

        •  no again (0+ / 0-)

          There is NO timeline, and NO nonzero tax rate on investment income, for which post-tax investments are equal to or better than pre-tax investments.  As also stated by Miggles in his/her reply, the benefit of the tax-deferred account increases with time, but is always positive.

          I didn't consider penalties paid for early withdrawal, or an increase in regular income tax rates with time, but of course these can't be calculated because they can't be predicted.

          •  Yes, again (0+ / 0-)

            How about one year?

            Pre-tax IRA: I invest $10,000. In one year, the IRA earns 10%. I then withdraw $11,000 (being now old enough to be eligible for withdrawals.) The entire sum of my withdrawal is now taxed at 33%, for a tax bite of $3630.

            Non-IRA account: I invest $10,000, on which I already paid a tax of 33%, or $3300. It earns 10% after one year. I sell the whole thing for $11,000. I am taxed $(11,000 - 10,000) x 15%, or $150. (The tax rate is lower because this is a capital gain.) My total tax bill in this scenario is $3450 over the two years.

            This may be an unusual scenario, but you cannot say that it is impossible.

            Let us all have the strength to see the humanity in our enemies, and the courage to let them see the humanity in ourselves.

            by Nowhere Man on Sun Dec 02, 2012 at 08:56:03 PM PST

            [ Parent ]

            •  no no no (0+ / 0-)

              In the non-IRA account, you have to pay tax on the $10K before you invest it.  So your actual investment  is $6700 and your gains on it are therefore 33% less as well.

              What you're calculating is apples and oranges. $10,000 before tax is not the same money as $10,000 after tax.

          •  Another *very* possible scenario (0+ / 0-)

            involves stocks that pay no dividends at all, but have enormous capital growth. Until very recently, Apple Computer was in this category.

            Ten years ago, you could have bought about 1,350 shares of Apple Computer for $10,000. Today, you could sell those shares for about $784,000.

            If that money were in an IRA, your tax bite would be something like $784,000 x 33% = $257,936. (Yes, you could spread that out over some years, but you'd still have to pay it.)

            If that money were in a post-tax account, your tax bite would be ($784,000 - $10,000) x 15% = 116,000.

            Which tax bill would you rather owe? It's possible that you could still do better with the IRA in this scenario, thanks to deferrals and re-investments, but I wouldn't bet my life on it.

            Let us all have the strength to see the humanity in our enemies, and the courage to let them see the humanity in ourselves.

            by Nowhere Man on Sun Dec 02, 2012 at 09:11:23 PM PST

            [ Parent ]

            •  no no no (0+ / 0-)

              If that money were in a post-tax acct, it wouldn't be $784K because you wouldn't have had $10K to invest. You'd have $6700 to invest (after paying 33% tax on the $10K you started with).

              So the total after growth would be $784K *0.67 = $525,000 only. And to add insult to injury, you'd still have to pay 15% on the capital gain.

              Sure you pay less taxes in nominal dollars, because you pay those taxes earlier rather than later. But you have less left over with post-tax investing, and that's what matters.

              Read my posts again. They are mathematically precise. The point is, with pre-tax you're investing more money, not the same money, if you start from the same amount in both cases.

              Incidentally, 'deferrals and reinvestments' have absolutely nothing to do with this. You don't pay cap gains tax until you sell, and you don't pay taxes on a retirement account until you sell.

              •  Sigh (0+ / 0-)

                You cannot always assume that an investor who can save X dollars by investing in an IRA would choose to invest the saved money in addition to the original basis of the investment. If I can save $1000 through bargaining on a new car, I'm not going to spend that $1000 on buying a bigger and better car. Similarly, I might choose to invest $13,300 in Apple Computer, instead of only $10,000, if I could do so. But I very well might not choose to do so.

                Seriously, any investor's risk tolerance only goes so far. Considering the very real possibility of losing that entire original investment (who knew, ten years ago, just how successful Apple would be today?), it might be very wise to take that tax savings and invest it elsewhere. (Like buying a hybrid instead of a conventional engine :-)

                Let's put it this way: By taking your reasoning to its extreme, a Roth IRA (in which the original investment is taxable, but taxes are never paid on withdrawals) is always a loser's game compared to a traditional IRA. I'd argue that the Roth IRA can be a good choice, depending on how I weigh the value of tax dollars saved today, vs. tax dollars saved in the future. (Keep in mind that both kinds of IRA have the same limits on annual investments, so $10,000 may be the maximum I can put into either one. In that case, if I want to maximize the amount available to me in retirement, vs. the amount available today, I'd have to choose the Roth IRA.)

                You may think I'm stretching to make this point, but to me you're stretching to assume that your reasoning covers all possible cases. I do understand your reasoning perfectly well, believe me. Your reasoning is fine; it's your assumptions that I'm arguing with.

                And I'm sorry if I wasn't clear, but "deferrals and reinvestments" have everything to do with it. What I meant was that my assumption is that the proceeds from the sale are immediately withdrawn from the IRA. This is a valid point to raise on your behalf, because in reality an investor is unlikely to withdraw the entire $784,000 in one year. If it's withdrawn over several years, this allows the remainder to be reinvested, and defers the tax bill for the reinvested sum. That does change the calculations -- probably, but not definitely, in favor of the IRA.

                Let us all have the strength to see the humanity in our enemies, and the courage to let them see the humanity in ourselves.

                by Nowhere Man on Mon Dec 03, 2012 at 04:42:53 AM PST

                [ Parent ]

    •  You left out the other part of my comment (0+ / 0-)

      which says:

      Of course, the deferral of taxes on capital gains and dividends can offset that disadvantage
      In that phrase, I'm referring to exactly the tax advantage that you described. However, I also wrote:
      but there's absolutely no guarantee that it will.
      In other words, investing in stocks and bonds is far from a sure thing. If you wind up with little to no capital growth due to market fluctuations, you may wind up taking a bigger hit if your money is inside an IRA than if it's outside of one. This is by no means certain, but it's a risk that older working people, in particular, should be aware of.

      Let us all have the strength to see the humanity in our enemies, and the courage to let them see the humanity in ourselves.

      by Nowhere Man on Sun Dec 02, 2012 at 05:33:32 PM PST

      [ Parent ]

      •  no again (0+ / 0-)

        "If you wind up with little to no capital growth due to market fluctuations, you may wind up taking a bigger hit if your money is inside an IRA than if it's outside of one."

        Tax-deferred is better if there is ANY capital growth, whether a little or a lot (as explained in my original comment). Of course it makes no difference if there is no capital growth. In neither case do you wind up taking a bigger hit etc. etc..

        Of course, the assumption is that other things are the same, i.e. the pre-tax and post-tax investments being compared are in the same investments and the growth is identical.

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