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We learned long ago that an all wind blows nobody good, but what about
the reverse? A good wind can blow bad to someone. So it is with the
commendable capital-gains tax cut enacted in 1997: Although it reduces
our taxes on investment profits, it makes providing for a secure
retirement a little harder and more uncertain.
Cutting the maximum capital gains tax rate to 20% while leaving the
maximum marginal income tax rate at 39.6% erased the tax advantage of
buying stocks to save for retirement in a tax-deferred account such as a
401(k) plan or in an individual retirement account. That's because all
withdrawals from such plans are taxed as ordinary income, even if much
of the account balances was derived from capital gains.
If you have $100,000 in an ordinary brokerage account with stocks that
cost you $25,000, lucky you. But you would pay $15,000 in taxes if you
liquidate those stocks for retirement income this year. Or, if you keep
your total income in the bottom tax bracket, the capital-gains tax will
take only 10%. But if those same stocks that cost you $25,000 were in a
tax-deferred account like a 401(k), you would pay full income tax rates:
At least 15% on bottom-bracket income and 28% or more on the rest, on up
to the maximum 39.6% marginal rate, depending on your other income and
deductions.
Of course, the more you traded in your taxable account, the more
capital-gains tax you paid along the way. All trading profits went
untaxed in the tax-deferred account until you cashed out the proceeds
during retirement. But if you were a buy-and-hold investor in stocks,
especially those that don't pay dividends, current law probably will
force you to pay a bigger tax bite in a so-called tax shelter than in an
account with no tax advantages.
The revolution in American retirement finance, in which more workers
every year depend on tax-deferred individual investment accounts rather
than defined-benefit pension plans, has a downside, after all.
On the other hand, most mutual funds are more advantageous in
tax-deferred accounts, because so many fund managers trade so
vigorously. Only a few funds are managed to minimize taxes. As so many
new investors find out to their annoyance, the mutual-fund shareholder
pays capital-gains taxes on gains realized by the fund, even when the
shareholder makes no withdrawal. And if the shareholder does sell his
shares at a profit, bingo! Another tax rate.
Confused? That's probably what Congress intended. The whole system seems
designed to leave people confused about their investment strategies,
passively accepting whatever whim Congress and the IRS write into their
next tax form.
This year marks the 25th anniversary of the IRA, and its legislative
history demonstrates what a mess the national government makes out of
private savings. Happy birthday, more or less.
In 1974, the IRA was created to allow persons without a pension plan at
work to save $2,000 a year and get a tax deduction. All investment
earnings would go untaxed until withdrawn in retirement. There would be
a penalty, of course, for earlier withdrawal.
Then in 1981, savings was more in vogue. Congress allowed everybody to
take the $2,000 tax deduction. For five years. Then the political
pendulum swung back. In 1986, the benefit of the full deduction was
limited to single persons with adjusted gross income under $25,000
($40,000 for couples), but others were allowed to keep contributing
without the deduction. Their IRA investment earnings would also go
untaxed until withdrawal.
In 1997, Congress changed the income limits for deductible IRA
contributions, using a formula for gradual elimination of the deduction
that itself will change every year for the next decade. Congress also
created Roth IRAs. These new ones operate in reverse: You contribute
without a deduction, but then you pay no tax on withdrawal.
In a move designed to give a boost to federal revenue, many people were
allowed to pay taxes on the value of a regular IRA and covert it to a
Roth IRA. The rules designed to forbid this option to people in the top
income brackets were so complicated that some taxpayers converted and
only later discovered they were not eligible, which forced them to
convert back.
Moving in the opposite direction, Congress also opened exceptions to the
penalties for withdrawals from regular IRAs before the normal minimum
retirement age of 59 ½. Now only the ordinary income tax - arduous as
it may be - is due if money is withdrawn from an IRA to pay for a
college education or a first home.
Confused? Why wouldn't you be? Confusion is the natural result of using
tax policy to change economic incentives to suit the whims of the
elected representatives of the people.
Taxing Retirement
Changing tax rates may have unexpected consequences
by Thomas G. Donlan
5/17/99
copyright Barron's Online
 
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