ikkyu2 (99.52)

Roth vs. the Evil Tax Monster

May 12, 2007 – Comments (6)

There's been a lot said about Roth 401(k)s and other tax-free investment vehicles.  The general idea is simple; you pay income tax on money, then use what's left over to put into the Roth.  Your money can experience capital growth and dividend or interest income in the Roth, tax-free, and it can be withdrawn, tax-free, during retirement.

So the trade-off is paying income tax today, versus paying annual capital gains taxes every year.  Annual cap gain/dividend and interest taxes, though capped at 15% now, murder long-term return via what's called the magic of compounding.  And cap gain taxes may go up in the future.  So the Roth can be a good deal.  For folks not anticipating their income tax rates to be lower in retirement, the Roth even beats the regular 401(k) or IRA.

But there are a couple wrinkles to the Roth plan I never hear addressed, on Fool boards or elsewhere.  Here they are:

1)  What if Congress institutes a national value-added tax (consumption tax) before you retire?  A lot of countries, Canada prominent among them, make most of their national tax revenue via a consumption tax.  If Congress decides to switch the US to this progressive model, Roth holders will be screwed.  Picture this: you pay your 30% income tax on the Roth.  In retirement, you later take your money out of the Roth.  But in order to actually use that money to buy anything, you have to pay another 30% in value-added taxes!  You've been taxed twice on the same money. You lose.

2)  Nothing's ever said about state tax rates.  Many states have a high state income tax.  Your Roth contribution is going to be taxed on state and federal income.  Your traditional contribution will not be.  If you're planning to earn money in a state with a high state income tax rate, but later will withdraw money from your retirement account while living in a state that lacks an income tax, the tax differential may be enough to favor a traditional 401(k) or IRA over the Roth version.

Lots of states have low income taxes, in fact.  I wonder how many retired people establish residency in a low-income tax state by buying a second home, just for this purpose?

3)  No one ever plans to take a loss on an investment.  But it happens.  If you've already paid tax on your money and just straight off invest it in stocks outside of a tax-advantaged vehicle, and you book a capital loss, you can carry that forward 3 years to offset the tax liability incurred by any non-taxable capital gains you might have also obtained during that time.  In that way, Uncle Sam eases the pain of taking a capital loss outside a tax-advantaged retirement account.

If you take a capital loss in either a traditional or a Roth vehicle, you book the full loss, no benefit.

This doesn't make the traditional or Roth vehicle a worse investment.  But if you're someone who's maxing out your tax-advantaged vehicles and still investing more on top, it has implications for asset allocation.

If you diversify, the way I see it is that you want the most conservative asset - your TIPS, say - in the traditional vehicle.  Aggressive growth is relatively penalized there, because you're (eventually going to be) paying income tax rates on growth that would be taxed under the lower cap-gain/dividend rate if it were occurring outside the account.

More aggressive vehicles, like S+P 500 index funds, you want in the Roth because you're expecting them to grow over time.

But what about the riskiest vehicles?  Say, the Peter Lynch / Hidden Gems style of investing, where you buy 5 small cap growth stocks, expect 3 of them to tank, 1 to in-line perform, and 1 to pull a ten-bagger?  With this model, if you are realistic, you're expecting to generate a loss - you just don't know which stock is going to produce it.  I think that's an argument (assuming you're maxing out your tax-advantaged vehicles already, with lower-risk investments) to do this kind of investing outside of a tax-advantaged vehicle so you can at least obtain the tax benefit of the loss you're planning to generate.

I would welcome the expertise of the CAPS community in response to these ideas; I've developed them myself and I may have missed something.