When President George W. Bush muscled the Jobs and Growth Act of 2003 through Congress, he changed the map for investing. With tax rates on equity returns slashed to 15 percent and higher limits on how much we can invest in retirement accounts every pathway for investing needs to be reexamined. It may be to your advantage to abandon the convenient plan offered by your employer. You could do better by investing independently.
But how do you know?
You start by seeing how each of the options performs with the same basic investment. I built a new calculator to do just that. For this column I assumed we start with $10,000 of pre-tax income. The calculator then figures how each of seven different tools for investing will work. (In practice you could be limited to a lower annual investment, given the contribution limits of IRAs and Roth IRAs.) For this column, I assume an investment period of 20 years and a gross return of 10 percent a year.
Results range from $48,653 to $27,612, depending on the investment vehicle chosen.
That’s quite a range.
No, this doesn’t mean you should abandon a plan with an employer provided match.
But if you have a 403(b) or 401(k) plan with no match and your plan options have high expenses, it’s time to invest elsewhere. Similarly, if you’ve been trying to hide from the taxman in a variable annuity that invests in equities, it’s time to change.
Why?
Lots of retirement dollars are at stake. They can either be in your pocket, in someone else’s pocket, or fed to the ever-hungry Internal Revenue Service. As always, the main levers are the expenses and taxes you have to pay. An investment option that offers low expenses and low taxes is likely to put more spendable cash in your retirement savings than an investment option with high expenses and high taxes.
All calculations were done assuming you are currently in the 25 percent tax bracket. I’ve also assumed that your future tax bracket will be 25 percent and that equity returns in taxable accounts are taxed at 15 percent, when realized.
Here are the results:
The winning vehicle is a Roth IRA with an index fund. Invested in a low cost equity index fund, it blows away the competition. If you pay income taxes on $10,000 of income you’ll have $7,500 to invest. Put it in a Roth IRA and invest in a low cost (0.20 percent expense ratio) equity mutual fund earning a 10 percent gross return and it will accumulate to $48,653 in 20 years— with no taxes to pay when you make withdrawals.
There is a tie for second place between an IRA and a Roth IRA invested in a managed equity fund. Whether you invest in an IRA holding a managed equity fund or a Roth IRA holding a managed equity fund, the end result will be the same. After all taxes are paid, both accumulate to $42,033. It may feel better to put $10,000 of pre-tax income into an IRA and pay taxes later, but you’ll have exactly the same spending power if you pay taxes and put $7,500 into a Roth IRA holding the same fund. In both cases I assumed a gross return of 10 percent, reduced by a 1 percent annual expense ratio.
If you expect that your future tax bracket will be higher than your current tax bracket, the Roth IRA is a better choice.
Naked Index Fund Investing places fourth. If you pay income taxes on $10,000 of income and invest the surviving $7,500 in a low cost equity index fund you’ll accumulate about $36,229. This assumes only 20 percent of the index funds’ annual return is taxed each year, and that all unrealized taxable gains are taxed at the end of the period. This is a reasonable expectation since major index portfolio turnover is about 4 percent and dividend yields are a small portion of total returns.
A Naked Managed Fund noses out a Qualified Plan Variable Annuity Managed fund. Here I assumed you invest $7,500 of after-tax income in a managed equity fund with annual expenses of 1.0 percent. The fund pays taxes on 50 percent of its return each year— a somewhat tax efficient fund— so you’ll end up with $34,721. Invest $10,000 of pre-tax income in the Qualified plan Variable Annuity and you’ll end up with slightly less, $34,315. If you’re a teacher or work at a non-profit institution where variable annuities are popular 403(b) plan choices, the expense and tax differences on typical plans eliminate the benefits of your choices. This assumes a typical VA expense burden of 2.1 percent a year. Many are higher.
The good news is that a new universe of choices— the five options that did better— is available.
A Non-Qualified Variable Annuity is the nag in this race. Take $10,000 of income, pay income taxes on it, and invest the $7,500 remaining in a typical contract with 2.1 percent total annual expenses and you’ll have only $27,612 after all taxes are paid at the end of the contract.
As the saying goes, it ain’t worth shootin.’
The bottom line: Being tax phobic has never been more expensive. Being tax and expense savvy has never offered greater rewards.
This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
Photo: Photo by Mikhail Nilov on pexels.com
(c) Scott Burns, 2022