Revisiting the myth of tax deferral

Tax efficiencies should be an integral part of any sound investment plan


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I’m puzzled why there are not more discussions and articles about tax efficiency and investments, particularly when it comes to the issue of tax deferral.

Of course, tax planning is far from “sexy.” The lead story in the most recent IMCA (Investment Management Consultants Association, of which I am a member) research quarterly was titled,  “Increased Tax Rates and Investment Strategy.”

Like the remarkable underestimation of the potential long-term power of compound interest in creating one’s fortune, there are too few discussions about the potential shortcomings of tax deferral and the significance of tax-efficient investment strategies.

I’ve beaten this drum for a long time. It was nearly three decades ago, when the transition to 401(k) plans was taking off, that I wrote a column that drew the ire of many of my fellow advisers and friends in the accounting profession. The abridged version goes like this: beware the myth of tax deferral. My point was to take a hard look at the long-term implications of tax-deferral plans and to recognize the potentially serious drawbacks in the future.

The future is here for some. There is often confusion about the benefits and mathematics of tax deferral, as well as pretax savings, because sometimes a tax-deferred account or investment only defers one from paying potentially more down the road. This may not always be to an investor’s advantage.

Owning a tax-deferred asset, like the stock of a good company or fund, in a taxable account is often wiser than holding the same fund or company in a tax-deferred account like an IRA or 401(k). If held in an IRA, that growth company or fund will eventually be taxed as ordinary income.  Ordinary income tax rates could be twice the level if the stock or fund had been held in a taxable account, sold, and taxed as a long-term capital gain. Remember, in investing, it is not what you make, but what you keep that matters most.

A conscious choice

Automatic savings can occur if a 401(k) is in place and can be terrific for the investor taking control of their retirement security and very profitable for mutual fund companies and insurance vendors. I think trends and events over the past three decades have given us a clearer perspective of winners and losers in the tax-deferral arrangement.

One reality has become quite apparent: People who do not create diversified tax efficiencies and who relied too much on tax-deferred investments in their long-term plans may find themselves hit with much greater tax burdens than they expected or needed to pay in later years. Individual tax rates have been largely declining for three decades, while few experts believe tax rates will be lower in the future.

The issue of tax efficiencies remains elusive because it sounds dull, dry and formidable – better left to accountants. It is anything but formidable, and I believe the matter of tax efficiencies resides in the same category as compound interest. It is considered dull and unexciting when compared to the latest investment scheme.

In truth, tax efficiencies should be an integral part of any sound investment plan.

Here’s a frequent example of mine, and it has to do with my favorite hypothetical company, XYZ:

Investor A has a $1 million investment in company XYZ, with a zero cost basis, held in a tax-deferred IRA savings account. Investor A also has $1 million directly invested in company XYZ stock in their personal trust or investment account, also with a zero cost basis.

On paper, both assets are worth the same, except for the significant difference of future tax liability. And if the client dies with a significant IRA, the tax burden on future generations may even be higher.

The obligation of the tax-deferred IRA is set at the income tax rate, which could currently be over 40 percent, or higher if ordinary income tax rates increase again. The sales of stock in a taxable account would be subject to a much lower long-term capital gains tax of barely 20 percent for even the highest-income investor.

Assuming a zero cost basis for this hypothetical example, the IRA investment could have an after-tax value of an estimated $600,000 while the stock investment in a taxable account could be worth as much as $800,000 – a $200,000 difference.

Some would call this found money, but in reality it’s a conscious choice to weigh long-term risks and benefits – and naturally unique to every investor. If investors are blinded or distracted by the allure of tax deferrals, they may miss out on the opportunity to have greater flexibility for future earnings.

I don’t believe that tax-deferred plans are inherently unhealthy, though the late Sy Syms said, “An educated consumer is our best customer,” and the same may be true in the realm of tax deferral. After all, why should people pay more taxes than they need to?

Tom Sedoric, managing director-investments of the Sedoric Group of Wells Fargo Advisors in Portsmouth, can be reached at 603-430-8000 or through thesedoricgroup.com.

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