Trading in Your IRA?[Fool on the Hill] April 19, 2000

An Investment Opinion

Trading in Your IRA?

By Bill Mann (TMF Otter)
April 19, 2000

One of the big arguments against frequent trading of stocks is that it is tax inefficient. Proponents of long-term buying and holding of companies point to the fact that as long as they do not sell, their capital is allowed to grow without being taxed. Taxes, coupled with brokerage fees, are known as friction costs. These two items are the money that one must pay in order to get into or out of equities.

Trading costs have plummeted as individual investors now have the option of online investing, with deep discounts all the way down to, well, zero with a $100,000 account minimum at American Express (NYSE: AXP). More democratic are the accounts with fees ranging from $5 to $30 from Schwab (NYSE: SCH), Waterhouse (NYSE: TWE), Ameritrade (Nasdaq: AMTD), and other deep discount brokerages. These transaction costs are a far cry from the full-service broker fees that run from the hundreds to the thousands depending on the value and number of shares in the trade. Transaction costs have fallen to the point that they are nearly irrelevant for all but the most frequent traders. Still, one would be Foolish to keep a running tally of how much money one has spent in trading over a year. Even with deep discounts, each trade fee is just a little less money that will work for you for the long term. And those $12 trades can add up.

But the biggest friction cost we have is taxes. There is a growing number of people who have solved this problem by using their tax-free accounts, either Individual Retirement Accounts (IRA), 401(k)s, or other tax efficient vehicles as their "trading accounts." In so doing, these investors are removing one of the other real criticisms that the Fools have about frequent trading -- that every time you do, Uncle Sam gets a bite. This, coupled with the fact that frequent traders are counting upon their skills of not only picking the right companies, but also picking them at the right time, is the core reason that we do not engage in this type trading.

But in an IRA, there is no tax friction. An investor can jump in and out of stocks as many times as he or she wants, and must only pay the transaction fees. So this MUST be a really smart thing to do, right?

Not so fast.

Certainly this is in fact much smarter than trading in and out of stocks in a taxable account. But remember this: the piper must be paid. There is always a hidden cost involved. We've been writing this stuff long enough that I'm not going to spend much time on frequent trading in taxable accounts, except to say that if you hold stocks for less than one year, you are taxed at your ordinary income rate, the highest being 39.6%. If you hold for more than one year, you are taxed upon sale at the capital gains rate, a maximum of 20%. Some frequent traders may in fact have some advantage over buy and holder's, but they'd better have a lot of one, since they're getting taxed through the nose for it. My tax liability for trading in 1999? Zero.

But IRAs don't have this same liability. IRAs and 401(k)s are taxed at the time withdrawals are made. Any transactions in the mean time remain tax efficient. But there is a flip side, one that this past week should make crystal clear. One of the advantages of a taxable account is that you can also take deductions for any investment losses. This is not available within an IRA. And each of us over our lifetime can certainly expect to make some investment mistakes. At these times, it is nice to be able to take a deduction against other current income.

Also, remember that in the end IRAs will be taxed as ordinary income upon withdrawal. This means that anything you have in your IRA will, again, be taxed at your current rate, up to 39.6%. Any long-term securities, no matter how long you hold them in a taxable account, will be taxed at the capital gains rate, or a maximum of 20%. So people who use the Phillip Fisher style of investing -- buying Motorola (NYSE: MOT) in the 1950s and never selling it -- create their own tax-free account, and at the end still only get taxed for capital gains.

The other big mistake here, one I am making right now, is assuming that tax levels are some sort of natural law. Remember, during the Carter administration personal income taxes were at nearly a billion percent (actually, the highest rates were in the 70% range). There is no rule anywhere saying that the government will not have dramatically changed the rules and levels on taxation by the time you retire. This is a neutral statement, because it could go either way, and probably, in the course of your lifetime, will do a little bit of both.

The other issue for your retirement account to remember is this: it is for your retirement. This, by design, is a vehicle to help you provide for yourself and your family in later years. So just as you should not be investing money that you cannot afford to lose now, you should not gamble with retirement money that you very well may need to survive for the 25+ years you can expect to live past the age of 65. Frequent trading is not, by definition gambling. But it does add your own ability to time the market into the equation.

Still, there are Fools who are not counting on their retirement accounts for sustenance later in life, as they already have other financial means to meet their needs. These are not people who are looking to the stock market to make themselves rich. In such cases, the IRA account may be truly looked upon as a source of "play money." If this describes you, and you have the urge to try out some theories about trading the market, have fun. But make sure to measure yourself up to a reasonable yardstick to determine if you are doing more damage by trading than you would have by buying and holding.

For everyone else, remember that the majority of Americans under the age of 40 do not expect Social Security to provide anything for them in later life. This means that your IRA, your 401(k), and your nest egg may very well be your safety net. Play with these things at your own risk.

Fiat Fool!

Bill Mann, TMFOtter on the Fool Discussion Boards