IRAs Are a Mixed Bag….

Yes, I know the financial planning textbooks are replete with advice toward maximizing the deferral of taxes. But tax deferral comes as a mixed blessing. On the one hand, most of us will be in a lower tax bracket at retirement, so deferring out of say a 35% bracket and into a 20% bracket makes some sense. You also get all that time to compound with no taxes. But it’s not all a bed of roses.

Tax brackets seem certain to rise, and deferring may not be the benefit it once was due to the uncertainty about future brackets. Additionally, a large percentage of IRA balances are invested in stocks and stock mutual funds, which on their own generally have a 15% tax cap. You lose that in an IRA. Furthermore, you can defer taxes on stocks outside of an IRA too by simply not selling them and realizing your capital gains. Additionally, the piled up profits in long-term stock holdings have the 15% capital gains tax forgiven at the death of each spouse. That means unsold stock gains outside of an IRA could go completely untaxed due to current rules on stepped up basis at death. Not so with an IRA, because built up profits will always be taxed at ordinary income tax rates when distributed from an IRA, and that is forced starting at age 70 ½. Death also does not relieve that burden.

Remember also that the investment advice community often has a conflict of interest in its love affair with IRA’s for clients. They shudder at the thought of all the lost commissions on the trades that would occur due to activity being tax shielded in an IRA, while the capital gains tax outside of an IRA may give a client second thoughts about selling once they’ve piled up a hefty gain. So commission velocity is greatly enhanced on IRA’s. Brokerage firms love that. Furthermore, high net worth clients are doing themselves no favor with large IRA balances. The estate taxation on IRA’s is also quite punitive when a joint estate exceeds $10 million currently. This is because the entire IRA balance would get double taxed by stacking a 55% estate tax bracket on top of a possible 35% income tax bracket on the entire balance. IRA beneficiaries would likely get 10-15 cents on the dollar in a case like this. If Congress does not act and the President does not issue yet another Executive Order, then the estate tax may soon apply to a lot more estates than just those over $10 million. Contrast that with a large position in Exxon stock that gets inherited and the hypothetical current $1 million position bought 25 years ago for $80,000 would have the $920,000 gain forgiven for capital gains tax, but the 55% estate bracket would apply alone. That would leave the kids four times as much value as the same Exxon held in an IRA.

So when considering your next IRA contribution, you need to think about the types of investments you would own. You would also need to consider your propensity to trade, because more frequent trading would argue for an IRA. You also need to consider IRA’s within the context of your overall financial position, and the possible size of your estate because it is quite possible the IRA could do you more harm than good.

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