There's a Better Way
Than With an IRA
By Albert B. Crenshaw
(c) The Washington Post
Sunday, February 4 1996; Page H01
The 1986 tax law made tens of millions of Americans ineligible for those glorious up-front tax
deductions on their IRAs. The next year, IRA contributions fell by two-thirds -- and they've kept
dropping.
But investment firms haven't given up. This time of year, they still try to persuade clients to put
$2,000 into individual retirement accounts anyway.
Their argument is that with an IRA, your earnings pile up, compounding untaxed. Yes, you'll be
taxed when you start withdrawing the money on retirement, but your total take will still be greater
than if you had the money in a regular account, subject to taxes every year.
I'm not convinced. Instead, I'd like to make the case for something I'll call a Low-Tax Retirement
Account (LTRA), which in many ways is superior to an IRA.
The LTRA is based on the best loophole in the tax code: You don't pay capital gains taxes on
something unless you sell it.
By contrast, dividends on stocks and interest on corporate and U.S. Treasury bonds, savings
accounts and certificates of deposit are taxed each year, even if you leave the proceeds in your
account.
The tax laws make common stocks that you buy and hold the ultimate tax-deferred investments. In
fact, you can put off paying taxes until you're dead -- and even then, your heirs can avoid them.
Let's say that in February 1981 you bought 100 shares of Fannie Mae. The price at the time was
$10 a share. Today, after stock splits, you own 1,200 shares, currently trading at $32.50. Your
original $1,000 investment is worth $39,000. How much tax do you have to pay on that $38,000
gain? Zero -- unless you sell the stock.
Fannie Mae and high-growth companies such as Coca-Cola Co., Microsoft Corp. and Johnson &
Johnson prefer to use most (and in some cases, all) of their profits internally, rather than bestowing
them on shareholders in the form of dividends. Under our tax laws, these companies are doing the
smart thing -- otherwise, their shareholders end up being taxed at both the corporate level and
another at the personal.
And that's the simple basis for an LTRA: If you buy shares of solid, growing companies that retain
and reinvest their earnings, you'll have a retirement account that defers taxes just like an IRA --
only better.
Why better?
When you sell stocks in your LTRA, your profits are taxed at the capital gains rate. IRA
withdrawals, on the other hand, are taxed at the same rate as ordinary, earned income. Under
current tax laws, the ordinary rate is higher than the capital gains rate for married couples with
taxable income over $94,250 and for singles over $56,550. In the future, it's a good bet that the
gap between the ordinary and capital gains rate will widen -- for all taxpayers -- but there's no
way to know what either rate will be, nor what your tax rate will be at retirement.
With rare exceptions, if you withdraw funds from your IRA before age 59 1/2, you have to pay a
10 percent penalty on top of the taxes. There's no penalty with an LTRA.
Even after the approved retirement age, you could be hit with a 15 percent penalty if you withdraw
more than $150,000 a year from your IRA. By contrast, with an LTRA, you can withdraw all you
want, whenever you want.
At your death, your heirs will inherit the stocks in your LTRA with a huge tax advantage; they'll
pay no capital gains tax at all on the increase in the stocks' value during your lifetime. Unlucky IRA
inheritors, on the other hand, can be socked with a big tax bill, at ordinary rates. Both, of course,
can be hit with estate taxes.
But there are pitfalls with an LTRA. For one thing, you need willpower and must pay attention to
your holdings. With an IRA, the penalties for withdrawals are so serious that they are incentive to
buy and hold.
Also, with an LTRA, you have to choose exactly the right assets. You need stocks with low
dividends, of course, but also stocks of solid, established companies that have a good chance to
thrive for another 20 or 30 years. The objective is not to sell.
What about letting a mutual fund manager choose your stocks? With an LTRA, that's tricky
because most funds aren't managed with the tax liabilities of shareholders in mind. Managers earn
their bonuses and their reputations on pretax results.
Fund shareholders have to pay taxes on the capital gains their funds incur (as well as on the
dividends). A fund that has high turnover -- that is, does a lot of buying and selling -- can generate
hefty taxes even in a poor year.
For example, in 1994, Fidelity's Destiny I fund produced capital gains of $253 for every 100
shares and dividends of $34 -- even though the fund had a total return of only $74. An investor in
a 28 percent bracket had to pay $80 in federal taxes alone -- an amount greater than the net
profits the fund earned!
The reason is that the fund sold stocks with gains but held on to stocks with losses. This strategy
may be smart, but the trouble is that taxpaying shareholders are completely at the mercy of the
fund manager. Even a fund that simply passes along its capital gains to shareholders each year
creates a bigger tax liability than an investor who never sells would face.
Still, some funds, by their nature, generate lower capital gains. The ideal is a small-cap stock fund
(high growth, no dividends) with low turnover, a low level of cash, a yen for strong companies and
a long track record. Unfortunately, few funds fill this bill, so some compromise is necessary.
Funds for the tax-conscious investor to consider include PBHG Growth, AIM Constellation and
Twentieth Century Ultra (small-cap but high turnover) and all the index funds that mimic the
Standard & Poor's 500 (low turnover but taxable dividends).
Also, keep a close eye on a relative newcomer, the Torray Fund, founded in 1990 and based in
Bethesda. The Value Line Mutual Fund Survey in a recent analysis said that "the driving force
behind [manager Robert Torray's] investment approach is the deferral of taxes, and, accordingly,
he intends to hold a significant proportion of investments indefinitely."
Value Line calculates that a $10,000 investment three years ago in the Torray Fund is now worth
$16,144, generating taxes along the way of only $321. By contrast, over the same period,
Lexington Growth and Income grew to $13,324 but generated taxes of $1,055, Value Line said.
Another source for tax analysis is Morningstar Mutual Funds, a subscription service available at
many libraries. For each fund, Morningstar compares pretax and estimated after-tax returns. For
example, over the past five years, the Berger 100 fund had an average after-tax return that was
only 9 percent lower than its pretax return. But for the Dreyfus Core Value fund, after-tax was 28
percent lower than pretax.
History is only a guide, and it's almost certain that if the market tumbles and shareholders bail out,
then fund managers will have to raise cash by selling stocks they've been sitting on for years. In
such an event, even Robert Torray's clients might be hit with sizable capital gains.
For that reason, if you decide to fashion at LTRA, put at least half of your assets in individual
stocks. That way, you're in control of your own tax destiny.
