Key Points:
- IRA and other non-taxable accounts are extra special because the IRS does not charge capital gains tax when you sell and reposition your investments, increasing the effective compounding rate of return.
- If you reposition your investments every 12 months (long term capital gains) and achieve a 12% yearly return, you could withdraw your money from an IRA after 6 years, pay the 10% IRS penalty and still come out ahead compared to a taxable investment account (under the assumptions of Scenario 1). The breakeven date lessens as the capital gains or yearly return rate increases.
- If you choose a buy and hold strategy in an IRA, the benefits are questionable compared to a taxable account, especially if your tax bracket does not when you retire after 59 1/2.
Albert Einstein once said, "Compounding interest is the most powerful force in the universe." He should have said, "Compounding tax free interest is the most powerful force in the universe..."
The money you contribute to IRAs and other non-taxable accounts (401K, Roth IRA, etc.) is extra special money. Everyone knows about the tax deferred benefits of IRAs. However, most people don't realize what really makes non-taxable accounts powerful -- no short term or long-term capital gains when you sell an investment in an IRA.
Capital gains taxes reduce the effective compounded rate of return in taxable accounts, which ultimately reduces the overall gain.
So, what does that gobbly gook mean?
Let's consider a hypothetical example. Suppose you reposition all your investments once a year by selling all of your old investments and buying new ones with the strongest Risk/Reward profiles for the prevailing market conditions. You do this in two accounts: (1) an IRA account; and, (2) a taxable account. Suppose you are able to achieve a 12% per year return in each account as a result of your investment activity. At the end of each year, you pay 15% capital gains tax on the taxable account (long term capital gains tax rate). You start out each account with a $10K pre-tax investment with no further contributions. Let's run the numbers...
Scenario 1: 12% appreciation per year; 15% capital gains tax rate; 30% ordinary income tax rate for 30 years; initial $10K pre-tax investment with no additional contributions.
| Year | Taxable Account Balance (after taxes) | IRA Balance (before taxes) | IRA Balance (after taxes) | Performance Difference (after tax) | | Year 0 | $7,000.00 | $10,000.00 | $7,000.00 | - | | Year 1 | $7,714.00 | $11,200.00 | $7,840.00 | 1.63% | | Year 2 | $8,500.83 | $12,544.00 | $8,780.80 | 3.29% | | Year 3 | $9,367.91 | $14,049.28 | $9,834.50 | 4.98% | | Year 4 | $10,323.44 | $15,735.19 | $11,014.64 | 6.70% | | Year 5 | $11,376.43 | $17,623.42 | $12,336.39 | 8.44% | | Year 6 | $12,536.83 | $19,738.23 | $13,816.76 | 10.21% | | Year 7 | $13,815.58 | $22,106.81 | $15,474.77 | 12.01% | | Year 8 | $15,224.77 | $24,759.63 | $17,331.74 | 13.84% | | Year 9 | $16,777.70 | $27,730.79 | $19,411.55 | 15.70% | | Year 10 | $18,489.02 | $31,058.48 | $21,740.94 | 17.59% | | Year 11 | $20,374.90 | $34,785.50 | $24,349.85 | 19.51% | | Year 12 | $22,453.14 | $38,959.76 | $27,271.83 | 21.46% | | Year 13 | $24,743.37 | $43,634.93 | $30,544.45 | 23.45% | | Year 14 | $27,267.19 | $48,871.12 | $34,209.79 | 25.46% | | Year 15 | $30,048.44 | $54,735.66 | $38,314.96 | 27.51% | | Year 16 | $33,113.38 | $61,303.94 | $42,912.76 | 29.59% | | Year 17 | $36,490.95 | $68,660.41 | $48,062.29 | 31.71% | | Year 18 | $40,213.02 | $76,899.66 | $53,829.76 | 33.86% | | Year 19 | $44,314.75 | $86,127.62 | $60,289.33 | 36.05% | | Year 20 | $48,834.86 | $96,462.93 | $67,524.05 | 38.27% | | Year 21 | $53,816.01 | $108,038.48 | $75,626.94 | 40.53% | | Year 22 | $59,305.25 | $121,003.10 | $84,702.17 | 42.82% | | Year 23 | $65,354.38 | $135,523.47 | $94,866.43 | 45.16% | | Year 24 | $72,020.53 | $151,786.29 | $106,250.40 | 47.53% | | Year 25 | $79,366.62 | $170,000.64 | $119,000.45 | 49.94% | | Year 26 | $87,462.02 | $190,400.72 | $133,280.50 | 52.39% | | Year 27 | $96,383.14 | $213,248.81 | $149,274.17 | 54.88% | | Year 28 | $106,214.23 | $238,838.66 | $167,187.07 | 57.41% | | Year 29 | $117,048.08 | $267,499.30 | $187,249.51 | 59.98% | | Year 30 | $128,986.98 | $299,599.22 | $209,719.45 | 62.59% |
By the end of the 7th year, you could withdraw all the money from the IRA account, pay the 10% IRS penalty, and still come out ahead compared to the taxable account. By the end of the 30th year, the IRA account will have 62% more money than the taxable account. That's the power of being exempt from capital gains tax in the IRA!
The higher the capital gains tax is, the higher the benefit of the IRA. Let's run the scenario again assuming we pay 30% short term capital gains tax (ordinary income tax) at the end of every year and achieve a rate of return of 15%.
Scenario 2: 15% appreciation per year; 30% capital gains tax; 30% ordinary income tax rate for 30 years; initial $10K pre-tax investment to start with no additional contributions.
| Year | Taxable Account Balance (after taxes) | IRA Balance (before taxes) | IRA Balance (after taxes) | Performance Difference (after tax) | | Year 0 | $7,000.00 | $10,000.00 | $7,000.00 | - | | Year 1 | $7,735.00 | $11,500.00 | $8,050.00 | 4.07% | | Year 2 | $8,547.18 | $13,225.00 | $9,257.50 | 8.31% | | Year 3 | $9,444.63 | $15,208.75 | $10,646.13 | 12.72% | | Year 4 | $10,436.31 | $17,490.06 | $12,243.04 | 17.31% | | Year 5 | $11,532.13 | $20,113.57 | $14,079.50 | 22.09% | | Year 6 | $12,743.00 | $23,130.61 | $16,191.43 | 27.06% | | Year 7 | $14,081.02 | $26,600.20 | $18,620.14 | 32.24% | | Year 8 | $15,559.52 | $30,590.23 | $21,413.16 | 37.62% | | Year 9 | $17,193.27 | $35,178.76 | $24,625.13 | 43.23% | | Year 10 | $18,998.57 | $40,455.58 | $28,318.90 | 49.06% | | Year 11 | $20,993.42 | $46,523.91 | $32,566.74 | 55.13% | | Year 12 | $23,197.72 | $53,502.50 | $37,451.75 | 61.45% | | Year 13 | $25,633.48 | $61,527.88 | $43,069.51 | 68.02% | | Year 14 | $28,325.00 | $70,757.06 | $49,529.94 | 74.86% | | Year 15 | $31,299.13 | $81,370.62 | $56,959.43 | 81.98% | | Year 16 | $34,585.53 | $93,576.21 | $65,503.35 | 89.40% | | Year 17 | $38,217.02 | $107,612.64 | $75,328.85 | 97.11% | | Year 18 | $42,229.80 | $123,754.54 | $86,628.18 | 105.14% | | Year 19 | $46,663.93 | $142,317.72 | $99,622.40 | 113.49% | | Year 20 | $51,563.64 | $163,665.37 | $114,565.76 | 122.18% | | Year 21 | $56,977.83 | $188,215.18 | $131,750.63 | 131.23% | | Year 22 | $62,960.50 | $216,447.46 | $151,513.22 | 140.65% | | Year 23 | $69,571.35 | $248,914.58 | $174,240.20 | 150.45% | | Year 24 | $76,876.34 | $286,251.76 | $200,376.23 | 160.65% | | Year 25 | $84,948.36 | $329,189.53 | $230,432.67 | 171.26% | | Year 26 | $93,867.94 | $378,567.96 | $264,997.57 | 182.31% | | Year 27 | $103,724.07 | $435,353.15 | $304,747.20 | 193.81% | | Year 28 | $114,615.10 | $500,656.12 | $350,459.28 | 205.77% | | Year 29 | $126,649.68 | $575,754.54 | $403,028.18 | 218.22% | | Year 30 | $139,947.90 | $662,117.72 | $463,482.40 | 231.18% |
By the 3rd year, the IRA account is 12.7% larger than the taxable account. You can withdraw your money after the 3rd year, pay the 10% IRS tax penalty and still come out ahead. After the 30th year, the IRA account will be 231% larger than the taxable account.
The biggest factors affecting the performance of IRA accounts compared to taxable accounts are: number of years of compounding, rates of returns, and capital gains tax rates.
The investment community typically advocates a buy and hold strategy for investors. Ironically, utilizing a buy and hold strategy in an IRA presents a mixed bag of benefits. With this strategy, an IRA can be useful if your tax bracket decreases after reaching the age of 59 1/2. However, withdrawals from an IRA are always taxed as ordinary income. Therefore, investors that buy and hold investments could lose out on a favorable long term capital gains tax rate which is currently at 15%. On the other hand, most investments in a buy and hold strategy will have some yearly taxable events in the form of distributions and/or dividends. These distributions and dividends will not be taxed in an IRA account.
In contrast to a buy and hold strategy, the benefits of an IRA account are clearly evident if the investor is committed to optimizing portfolio performance by selling weak positions and buying strong positions with good Risk/Reward profiles. In essence, the IRA account stops Uncle Sam from dipping his paw into your honey jar every time you decide to sell an investment.
Consider the performance of Dr. Agarwal's track record, which has been representative of the Kinetic Financial investment techniques for the past 8 years. His IRA balance was $74K in 1999. After 6 years of annual contributions totally $16.5K, the account balance grew to $489K by the end of 2004! If capital gains taxes were taken out along the way, the performance would have suffered significantly.
In conclusion, IRA money is very, very, very special money. Take advantage of these accounts every opportunity you have. Don't use the excuse "I don't want to wait until I'm 59 1/2 to access my money." When utilized properly, you can derive tremendous benefit from these accounts, even if you have to access the money early. The sooner you invest, the more you'll personally benefit from tax-free compounded returns.
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