Investing in an IRA provides a substantial tax benefit over a regular investment account because you defer or completely avoid paying taxes on growth. You probably know that. But the magnitude might surprise you.
Tax drag, or the amount you pay annually in taxes, can reduce your investor returns by an estimated 1.36% in a taxable account, according to analysis by automated investing service Betterment.
For you, it means that if you have not already maxed out your IRA for 2014—do it now. It’s one of the easiest way to boost your long-term returns.
In fact, even if you don’t have cash on hand to do it, we recommend pulling money out of your taxable account and paying a small tax bill to max out your IRA on a one-time basis. The contribution limit is $5,500 if you’re under 50, $6,500 if you’re 50 and older).
Pay taxes? Yes, you heard right. We’re recommending paying a small, one-time capital gains tax this year (okay, technically in about a year, when 2015 taxes will be due) in order to get much bigger tax-free gains in the future. Here’s why it works.
Reduce Your Tax Exposure
When you have money invested in a regular investment account, it’s growing—but at a reduced rate compared to an identical IRA account, because of taxes that are assessed annually. How so? A taxable account, even one that’s passively managed, generates some taxable income in the form of dividends and possibly capital gains. The precise amount of the tax hit depends on the funds that make up your portfolio, and whether market fluctuations necessitate a rebalance. But, because you have to pay those taxes each year, your after-tax returns are lower in a taxable account than in an IRA with the same allocation.
Example “Tax Drag” Scenario
To illustrate, our investment team ran two backtests1 of a simple portfolio containing 70% SPY (S&P 500) and 30% TIPS (Treasury Inflation-Protected Securities) from Jan. 1, 2000, to Dec. 31, 2013. The analysis showed that when invested in an IRA, that portfolio would have had an internal rate of return (IRR) of 8.94%.2 The same portfolio in a taxable account would have had an IRR of 7.52% after taxes over the same period.3 This gives us a reasonable estimate for the “tax drag” in a taxable account—1.36% per year—for this simple two-fund portfolio over one sample period.4
This figure does not include taxes paid on the liquidation of the investment. That would increase the tax hit in the taxable account. Gains on withdrawals from a taxable account are taxed as capital gains, subject to a more favorable long-term rate if the assets being sold were held for more than a year.
Both types of IRAs, Roth and traditional, offer tax-free growth, year-to-year. However, the Roth has the additional advantage of also being tax-free on withdrawal. With a traditional IRA, distributions are taxed at the account owner’s ordinary income tax rate on the entire amount of the withdrawal.
Returns Dragged Down
Let’s look at a simple example of the kind of trade-off you might make to sell out of your taxable account in order to fund an IRA, and why it’s worth it.
Say you deposited $5,000 into a taxable account over a year ago, and it has appreciated 10%, giving you a balance of $5,500. The original investment of $5,000 is your basis, and $500 is what you have earned in returns. When you withdraw all $5,500, you might owe around $75 in taxes.5 If your basis is higher, you’ll owe less. If your basis is lower, you may owe more.
If you pay the taxes on the withdrawal ($75) today, and reinvest the rest ($5,425) into an IRA, you’ll be much better off in the long term. The more time goes by, the more striking the impact of that difference in annual return. Assuming 30 years of tax-free growth, and the estimated difference in IRR from above, you would wind up with 46% more: $70,798 in the IRA, versus $48,422 in the taxable account.
All of the assumptions here are just reasonable estimates. Every portfolio has a different degree of tax drag depending on the amount of trading that occurs each year, which may result in gains, and the amount of dividends distributed and the nature of the dividends. There is no one number you can use as a rule of thumb.
Even if the annual tax drag on your portfolio is a fraction of the tax drag in the example above—and you can let the funds grow in your tax-advantaged account for even a few years—you are still better off moving the money out of your taxable account and into an IRA, if the tax hit on the withdrawal is modest.
Make a Rational Tax Decision
If you’re actively saving for retirement, there are only a few reasons to not take money from the taxable pot and put it into the tax-advantaged pot. Perhaps that money is invested in a low-risk portfolio as your Safety Net fund (bear in mind that you can also also use your Roth contributions as a kind of emergency fund), or your income bracket is too high to qualify you for an IRA contribution. Or, perhaps you foresee a liquidity need in the near future, such as education expenses. Those are good reasons to keep your money where it is.
But, if none of these apply to you—and potential taxes are the only thing stopping you—then you will likely earn more over time by making the switch. While it feels counter intuitive to actively incur a tax bill, part of that unwillingness is a well-known psychological phenomenon called irrational tax aversion. Studies have shown that when presented with a tax bill, people are likely to do what they can to avoid it—even if it means paying more in other ways.
At Betterment, our Tax Impact Preview tool provides an estimate of the tax cost you will incur when withdrawing a specific amount from your taxable account. Additionally, our TaxMin algorithm works to minimize that tax, by selling tax lots in the most efficient manner possible. These tools allow you to make rational tax decisions; you may find you wouldn’t owe all that much tax at all, or you may even realize a capital loss on the withdrawal, which could give you another deduction.
Your tax liability will depend on your tax personal situation. Betterment is not a tax advisor and you should consult a tax professional.