Post of the Day
April 20, 1999
Eyes on the Wise Folder
Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light.
Subject: Re: Candidate for Wise Quote
I apologize that it took me so long to compose this response. I still think it's relevant (plus I put a lot of work into it) so here it is.
Dlcasey originally questioned Ric Edelman's comments about holding Microsoft in an IRA because you could end up end the highest (39%) tax bracket. Mr. Edelman suggested that holding Microsoft in a taxable account was better since long term cap gains was only 20%. An interesting discussion ensued with the normal tangential topics.
Finally DHatch says:
Heck, why not go for the 39.6%!
Ok, you asked for it....
I have to admit that I've thought about this problem a lot. It occurred to me early on that employing Foolish investing techniques could push a traditional IRA up to the point where retirement distributions would be in the highest marginal tax bracket. Since this tax bracket is nearly twice the long-term capital gain rate, it calls into question, at least in my mind, the efficacy of a traditional IRA. As has been pointed out, if one is savvy (or Foolish) enough to identify a Microsoft outside a traditional IRA and hold it for 30 year or more, one will have a very comfortable retirement with a maximum of 20% paid in taxes. But there is still more to it than that. Now we have the option of a Roth IRA. If one could purchase a Microsoft in a Roth IRA, the whole kit and caboodle is tax free.
But what about the Foolish Four, or Rule Maker investing? Are you really better off stashing money in a traditional IRA if you're going to end up in the highest income tax bracket in retirement? There are a hundred ways to look at this and as always everyone's situation is different. But here are a couple of scenarios that I would like to compare.
1) A traditional IRA, tax-deferred growth with withdrawals taxed as income
2) A normal, taxable investment account with turnover and capital gains taxes paid
3) One or more stocks held for 30 years in taxable account, no turnover and no gains until retirement then only as needed
4) A Roth IRA, tax-free growth and withdrawals
Within each of these scenarios, we will assume 20% growth. (We want to get those numbers up there to make sure we hit the maximum income tax bracket.) Imagine that one's investing life begins at 40 and you start with $10K. With a 20% CAGR, that will grow to almost $2M inside a traditional or Roth IRA, or in our "Microsoft" option (#3) where no capital gains taxes are paid. In a regular investing account you pay the taxes on the gains each year and the account grows to just $740K. Now here's the reason I started our investment at age 40.
You must begin taking distributions from a traditional IRA at age 70.5. (Roth IRAs can wait longer but for the sake of simplicity we'll start withdrawing then, also.) So we've managed to save this money for the longest possible time. I also looked up the minimum distribution table at http://www.irs.ustreas.gov/prod/forms_pubs/graphics/15160x17.gif. The second column of the following table is the divisor that indicates what portion of the IRA account MUST be distributed at each age. (I have "ellipsised" the tables because of the length of this post. If you want to challenge my calculations, I'll be happy to send you the spreadsheet. Excel 97 for Win only.)
age divisor acct value distribution leftover 70 16.0 $1,978,135.95 $ 123,633.50 $1,854,502.45 71 15.3 $2,225,402.94 $ 145,451.17 $2,079,951.77 72 14.6 $2,495,942.12 $ 170,954.94 $2,324,987.18 ... 87 6.1 $7,349,618.55 $1,204,855.50 $6,144,763.05 88 5.7 $7,373,715.66 $1,293,634.33 $6,080,081.34 89 5.3 $7,296,097.60 $1,376,622.19 $5,919,475.41So it takes 20 years before you are forced to take out more than the annual growth in the account. Total distributions by age 89 are almost $12.5M. In the first year of distributions, your tax (according to today's tax rates) would be approximately 27%. (From the tax rate schedule at http://www.irs.ustreas.gov/prod/forms_pubs/graphics/10311g87.gif using single filing rate, 13,896.5 + .31 * (123,633.50 � 61,400) = 33,188.89).) At 89, the tax is 88,699.5 + .396 * (1,376,622 � 278,450) = 523,575.61 or 38% of the income. Not wanting to run the tax on all the amounts in between, I will estimate a 35% average on the tax (the later years have higher incomes and so the increased tax carries a heavier weight) meaning that you will see about $8.125M of that $12.5M distributed over 20 years.
Having fun yet? Let's do the F4 in a taxable investment account. Since there are no minimum distributions, we will assume a withdrawal of 5% each year per the Rule of 20. (That is, if you can live on 1/20 of your assests, you can live indefinitely without running out of money.)
age acct value distribution leftover 70 $ 740,085.15 $ 37,004.26 $ 703,080.89 71 $ 815,573.83 $ 40,778.69 $ 774,795.14 72 $ 898,762.36 $ 44,938.12 $ 853,824.24 ... 87 $ 3,858,058.37 $ 192,902.92 $3,665,155.45 88 $ 4,251,580.33 $ 212,579.02 $4,039,001.31 89 $ 4,685,241.52 $ 234,262.08 $4,450,979.44Total withdrawals are $2.17M. This is still paying the maximum 20% long term rate on the gain every year. In this case, the amount continually grows and you are never forced to empty the account.
We're up to option 3. This time we bought Microsoft (or equivalent) is a taxable account and held for 30 years. Now each year we pull 5% and pay the capital gains and live on the rest. The unsold portion continues to grow at 20% per year.
age acct value distribution leftover 70 $ 1,978,135.95 $ 98,906.80 $ 1,879,229.15 71 $ 2,255,074.98 $ 112,753.75 $ 2,142,321.23 72 $ 2,570,785.48 $ 128,539.27 $ 2,442,246.20 ... 87 $18,350,107.30 $ 917,505.37 $17,432,601.94 88 $20,919,122.32 $1,045,956.12 $19,873,166.21 89 $23,847,799.45 $1,192,389.97 $22,655,409.48Total withdrawals are $9M with you seeing $7.2M after the capital gains taxes
Ok, last one. This is the Roth IRA. This will be the same as #1, the traditional IRA, except without the income taxes. This means that you get to see the full $12.5M.
Here's the summary:
1) Traditional IRA - $8.125M with almost $6M in the account
2) Taxable account with turnover - $2.17M with a growing $4.45M account
3) Buy and Hold forever - $7.2M with a growing $23M account
4) Roth IRA - $12.5M with almost $6M still in the account
Obviously, all this is premised on today's tax laws. Furthermore, if you ran numbers starting at age 59 when you can first take IRA distributions, these numbers might change. And don't get me started on adjusting for inflation.
What do we learn from this? First thing is that I found that figuring this stuff out is tedious. Second is that Buy and Hold looks like pretty good work, if you can get it. Beyond that, I'm not sure this exercise is worth much for general knowledge. There are too many variables for which I had to make too many assumptions. But it is somewhat illustrative because it gives me a clearer picture of the relative merits of retirement investing under a certain set of conditions. The one thing I think it strongly suggests is that traditional IRAs ARE worthwhile even if you end up in the 39.6% bracket. And if you can pay the taxes now, Roth IRAs are definitely better. Whether you really need a $1M+ distribution when you are 89 is a question that I won't attempt to answer here.
One other important thing: I agree with Ric Edleman (and others here) but for a different reason. The Buy and Hold strategy works not because of the lower tax bracket, but because most of the money remains in the form of stock and continues to grow. It doesn't matter that the capital gains rate is 20% and the maximum income tax rate is 39%. It grows best because most of the money is never taxed at all for 50 years. Look at the size of the account at age 89: $23M. Even if you liquidated at this point you would have more than $18M after taxes. That's as much as the combined value (distributions plus remaining) of the Roth account plus you've already spent $7.2M.
So, all you have to do is identify today's budding Microsofts. No problem, right?
Fool on! Phool off!