I aver most investors have a retirement account – either a 401(k) or an Individual Retirement Account (IRA). These accounts certainly have their benefits. They allow you to reduce your current income tax liability by the amount of your deduction, and they allow your investments to compound tax-deferred.
But the day will eventually come when you’ll withdraw from your retirement account. The general rule is you can withdraw in the year you reach 59 ½ years. On the other side, you must start to withdraw the year you reach 70 ½.
When you withdraw, you’ll discover the free lunch isn’t so free after all: Whatever you withdraw will be taxed at your marginal income tax rate, not the lower long-term capital gains or the qualified dividend income tax rate.
This can impose unanticipated costs, which I’ll explain by way of example.
Let’s say you’re in the 28% marginal income tax bracket, where the qualified dividend tax rate and the long-term capital tax rate are 15%. Now, let’s say you invest $10,000 in a dividend-paying stock. The stock pays $1,000 in annual dividends. In 30 years, the stock appreciates to $50,000.
Before Retirement (Accumulation Stage)
|$10,000 Initial Stock Investment Inside a Retirement Account||$10,000 Initial Stock Investment Outside a Retirement Account|
|Initial Income Tax Deduction:||$2,800||None|
|Annual Taxes Paid on Dividends Received||None||$150|
|Taxes Due if Stock Is Sold With a Gain (Short-Term)||None||28% on Gain|
|Taxes Due if Stock Is Sold With a Gain (Long-Term)||None||15% on Gain|
|Taxes Due if Stock Is Not Sold||None||None|
When time value of money is factored in, you could argue that you should always invest within a retirement account. If only life were colored in such distinct shades of black and white, but it isn’t. Life is enveloped in endless shades of gray.
What if an emergency arises and you need to sell the investment before age 59 ½? A withdrawal from a retirement account will be fully taxed at the marginal income tax rate –28%. In addition, you’ll incur a 10% penalty on the full withdrawal. If a stock held outside a retirement account is sold, only the gain will be taxed, and taxed at the 15% capital-gains tax rate if held longer than a year.
Let’s say that in two years of the initial investment, the stock has appreciated to $15,000, plus paid two years of dividends ($2,000). The total is $17,000. The proceeds from a $17,000 withdrawal from a retirement account before age 59 ½ comes to $10,540 [$17,000 x (1 – 0.28% – 0.10%)].
In comparison, the proceeds when the stock is held outside the retirement account come to $15,950. You receive your initial investment of $10,000 back, and you pay tax on the $5,000 gain and the $2,000 in dividends at a 15% rate. (Of course, the initial distribution to the IRA lowered the tax bill by $2,800, so the IRA contributor also has use of $2,800.)
When it comes to withdrawals, we find another shade of gray. Let’s say you are at an age where you must take withdrawals, and that you must withdraw a minimum of 5% of the account balance annually.
In Retirement 30 Years Later (Distribution Stage)
|Stock Held Inside a Retirement Account||Stock Held Outside a Retirement Account|
|Dividends Received (Net of Taxes)||$30,000||$25,500|
|Mandatory First-Year Withdrawal**||$4,000||None|
|Second-Year Dividends (Net of Taxes)||$1,000||$850|
|Mandatory Second-Year Withdrawal||$3,850||None|
*Assumes no more appreciation after the 30th year.
** Assumes withdrawals from dividends, not principal
If you are an inveterate saver, holding stocks outside of a retirement account can be a good thing. Keep in mind, those mandatory withdrawals will be taxed at a 28% tax rate. The first year, you receive $2,880 net of taxes, not $4,000. The second year, you receive $2,772, not $3,850.
And if you really have a long-term perspective – say, generational – the $40,000 gain will incur no tax when it is bequeathed to a decedent: His cost basis is raised to $50,000. Traditional retirement accounts have no step-up in basis.
A case can be forwarded that holding a good dividend stock outside a retirement account is the better option.
Of course, I have to offer a caveat: My examples are for illustrative purposes only. Things get complicated when you wander off the well-manicured lawn of tax theory into the tangled nettle of tax reality. As always, where taxes are involved, consult a professional tax accountant.
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