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Friday, April 27, 2012

IRAs and capital gains

There exist investment advisers who believe that the primary advantage of an IRA is the possible difference in tax rates at the beginning and at the end.  I long ago realized that this was not the case and that the main advantage came from the fact that the government lets you keep those taxes and those taxes grow too.  I was talking to a friend, Adam Madison on this blog, who very quickly reduced my lengthy explanation to one simple sentence:  In a IRA you don’t have to pay capital gains taxes.  This is disputed here and there.

Let’s consider three different cases  In each case we will use 10,000 pretax dollars.  Assume your marginal rate for the whole 10,000 is 30% now and in the future .  (We will omit the possibility of an added advantage of being in a lower tax bracket later which is a minor advantage for most of us.)  Let’s say we leave the money in until it doubles.
X         Before IRAs:  You take the $10,000 and pay the tax up front and put the remaining $7,000 into a regular investment account.  In 14 years it grows to $14,000 and you owe capital gains taxes on the $7,000 gain in the account.  You have $14,000 minus that tax.
Y        You take the same $10,000 and pay the tax up front and put the remaining $7,000 into a Roth IRA.  In 14 years it grows to $14,000 and you owe no taxes on that $14,000.
Z        You pay no taxes at the outset and put the $10,000 into a regular IRA.  14 years later you take out $20,000 and pay 30% in taxes leaving you $14,000 after taxes.  Your $7000 doubled without a capital gains tax.
(Z is the one where it is harder to see how it is happening.  The 10K in the account can be thought of as $3,000 of taxes that the government lets you keep plus the (after tax) $7,000 that is yours.  Your $7,000 doubles, but the $3,000 of taxes that the government LETS YOU KEEP doubles also, and it is yours!    That second $3,000 is the real benefit of the IRA and it matches the regular taxes that you will owe on the net increase of $10,000.  One might say that the “growth of the taxes pays the taxes on the growth.”)


  1. Well said, and I agree with your analysis. I was earlier confused a little by the fact that we were discussing the benefits, or lack thereof, in special rates for capital gains and dividends. This effect of being able to grow pre-tax dollars in an IRA is an inherent benefit of the the IRA rules which are not really related to preferential tax rates for dividends and capital gains. Your analysis would be just as true if there were no preferential tax rates.

    I believe what triggered your comment was my saying that capital gains and dividends are earned by virtually only the wealthy. Your point is well taken that retirement accounts receive a large chunk of the annual dividends and capital gains. But even so, the owners of the IRAs and other retirement plans still do not receive an additional benefit for lower tax rates on dividends and capital gains.

    Thank you for the examples. Very interesting.

  2. Thank you.
    Do you know what percentage of capital gains taxes are paid (directly or indirectly) by which income groups? This has an aura of being rich peoples money, but a lot of it is in pension funds, 401Ks etc.

    Do you know how much money is held in those tax deferred accounts? I don't think it is enough to balance our books by any means, but however much it is, some 20-30% of it is uncollected taxes that belong to the government.

    What measure of income inequality do you think is the best? or some that are good.

  3. To characterize a defined set of personal assets that are tax deferred, by statue, as “uncollected taxes that BELONG to the government” is a little scary. I would suggest that it does not belong to the government until I pay it.

    1. A. Since I can't get to it until I pay the taxes so it seems that future taxes are government property that I am holding.
      B. I am thinking of it in the same sense as the balance sheet that I think the Govt should be required to produce every year. You project obligations to SS and Medicare etc and project income from taxes every year for the next X years.