Have You Suffered A Tax Tragedy?

I've been a tax professional for 25 years and it pains me to see people making dumb tax moves. And I think it is a dumb tax move to buy capital assets such as stocks and growth mutual funds inside an IRA or 401(k) plan.

I call this a Tax Tragedy. A Tax Tragedy is when you pay more taxes than required to pay by law. A Tax Tragedy causes you to lose tax deductions. A Tax Tragedy is when you pay much higher tax rates than you need to pay.

Tax Tragedy Number One: Capital gains inside a Retirement Plan.

When you have a capital gain inside a retirement plan it is Washed Out. You get no benefit from very low tax rates on capital gains. All Distributions of earnings are taxed as ordinary income. Your tax rate can be 35% or higher, while long term capital gains tax rates range from 0% to 15%.

Example:

Let's say you have invested $100,000 in your 401k and it has grown to $120,000 after a few years. You then sell the investments, realizing a $20,000 capital gain. If you take a distribution of the $20,000 it is added to your other income, and you could lose up to 35% of it in additional income taxes. If the capital gains had been realized outside a retirement plan, you would have paid no more than 15% on the $20,000 gain. The difference is 20% of your gain, or $4,000 in this example.

Tax Tragedy Number Two: Capital Losses inside a Retirement Plan.

The trade-off for investing in stocks and growth mutual funds is that sometimes they lose money. When we sell these losers we have a realized capital loss. You can offset capital losses against capital gains, and then deduct up to $3,000 per year against ordinary income. Excess loss amounts can be carried over and used in the future. When you're in a high tax bracket, the tax benefits from capital losses are significant.

Example:

Let's say you invested $100,000 in stocks in your 401(k) and you sell them when their value has declined to $80,000. You have a $20,000 realized capital loss. If the capital loss had occurred outside the 401(k) plan you could use it to reduce your other taxable income. But now it cannot be deducted on your tax return and it can't used to reduce taxes on the other capital gains you might have.

Tax Tragedy Number Three: Nondeductible fees and expenses.

Millions of people have their IRA and 401(k) accounts in mutual funds. These funds charge about six different kinds of fees--many of them hidden. The total fee can exceed three percent per year.

And it doesn't matter how much you lose in the stock market either--the fund companies still take their fees. If you are with a bank or brokerage firm they take additional fees. And these fees and expenses are not deductible against other taxable income.

Summary:

The best reason to do an IRA or 401(k) is for the current tax deduction. If you qualify for the deduction you should take it. If you qualify for a Roth IRA, then you should do that also.

But don't expose yourself to nondeductible capital losses.. Don't suffer the tragedy of converting LOW tax-rate income (capital gains) to HIGH tax-rate (ordinary) income.

Do NOT put your long term capital investments inside either an IRA or a 401k. Especially when they can lose money.

A Possible Solution

I like retirement plan investments that:

-- Never go down in value (no losses)

-- Don't charge you fees, sales charge or commissions

-- Can provide you guaranteed lifetime income


The only program I've ever seen with all of these features is a tax-deferred fixed or indexed annuity sold by a life insurance company. If you go with an A-rated company your money is safer than any place else you can put it.

Like retirement plans, these annuities can be passed on to kids and grandkids while bypassing probate. Indexed annuities can be structured to go up with the stock market and earn above-average returns.

Please note that fixed annuities are much different from variable annuities sold by stock brokers. Variable annuities have high fees and can lose you money. I'm not a fan of variable annuities for these reasons.

Unlike IRAs and 401(k) plans there are no contribution limits on after-tax contributions to tax-deferred fixed annuity contracts. To minimize taxes, place your CD money inside a tax-deferred investment vehicle, rather than earning taxable interest income that you don't need.

Using a guaranteed tax-deferred insured investment approach is both safer and better than an after-tax nondeductible IRA. And it also won't cause you to suffer a Tax Tragedy.