Pur Autre Vie

I'm not wrong, I'm just an asshole

Monday, May 23, 2016

Non-Taxable Stocks: Traditional vs. Roth

Just a quick note on the recently published finding that only about a quarter of U.S. stock is held in taxable accounts.  This is an important fact about the world and in general it's important to pay attention to this sort of thing, so I'm glad this was published.

That said, I just want to observe that the report treats traditional IRAs as non-taxable.  And that's of course true:  when you make an eligible contribution to an IRA, that money is not counted as part of your income and so your income taxes are reduced.  (This is often expressed as contributing "pre-tax dollars" to your IRA.)  Also, when you buy and sell stocks within your IRA, you don't incur capital gains taxes the way you might in a taxable account.

But in another sense, stocks held in traditional IRAs are not really exempt from taxes.  When the taxpayer withdraws money from a traditional IRA (mandatory withdrawals begin around age 70), the withdrawals are taxed as income.  And for many (all?) individuals, the income tax rate is higher than the capital gains tax rate.  The accounts are tax-sheltered, but the government has already taken the hit.  If 100% of U.S. stocks were held in traditional IRAs, the government could anticipate a lot of future revenue from those accounts, and there would not necessarily be reason for concern (at least, on the grounds of future tax revenue).

By contrast, once money is invested in a Roth IRA, it has permanently exited the picture.  Roth IRAs are funded with "after tax dollars"—the taxpayer gets no deduction in the year the funds are contributed.  Instead, the benefit is that the investor pays no capital gains or income tax when withdrawing the money.  There actually aren't any mandatory withdrawals from Roth IRAs, but if there were, they wouldn't generate any tax revenue.

I'm not sure Roth IRAs are any better or worse than traditional IRAs if you are looking at the entire life cycle.  But if you take a snapshot of stocks in taxable vs. non-taxable accounts, as this report has done, then the 25% headline number might be misleading.  A lot of stock is held in "non-taxable" accounts that will be taxed when the stock is sold—and quite often, that tax rate will be higher than the tax that will be paid on accounts that the report codes as "taxable."


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