Taxes are typically our most significant lifetime expense (yes, even larger than our kids). That’s why I’m puzzled that there aren’t more discussions and articles about tax efficiency and investments—particularly when it comes to the issue of tax deferral.

There are myriad posts on the importance of expense ratios, performance, and management but very little is ever written on the significance of tax minimization as a portfolio is constructed. Tax planning is far from “sexy” except to an accountant or tax attorney …and me. Like the remarkable underestimation of the potential long-term power of compound interest in creating one’s fortune, there are too few discussions about the potential shortcomings of tax deferral and the significance of tax-efficient investment strategies.

I’ve beat this drum for a long time. Part of it is due to my personal belief that none of us get something for nothing. Sometimes it is far better to pay the proverbial (tax) piper now rather than later.

The future is here for some

About three decades ago, when the transition to 401(k) plans was taking off, I wrote a column that drew the ire of many of my fellow advisors and my friends in the accounting profession.

The abridged version goes like this: beware the myth of tax deferral. My point was to take a hard look at the long-term implications of tax deferral plans and to recognize the potentially serious drawbacks in the future, especially if you need to dip into those savings sooner than you might have expected.

There is often confusion about the benefits and mathematics of tax deferral and pre-tax savings. Sometimes, a tax-deferred account or investment only defers one from paying potentially more down the road. This may not always be to an investor’s advantage; in some cases, old-fashioned ways of saving investment might make more sense. Owning a tax-deferred asset, like the stock of a good company or fund, in a taxable account is often wiser than holding the same fund or company in a tax-deferred account like an IRA or 401k. If held in an IRA, that growth company or fund will eventually be taxed as ordinary income. 

Ordinary income tax rates could be twice the level if the stock or fund were held in a taxable account, sold, and then taxed as a long-term capital gain. This is why it’s important to remember that it’s not what you make, but what you keep (after taxes and expenses) in investing that matters most.

Automatic savings can occur if a 401k is in place. It can be terrific for the investor to control their retirement security and profitable for mutual fund companies and insurance vendors alike. But looking at the trends and events over the past three decades has given us a clearer perspective of winners and losers in the tax deferral arrangement.

Building a tax-efficient investment strategy

One reality has become quite apparent: people who do not create diversified tax efficiencies and rely too much on tax-deferred investments in their long-term plans may be hit with much more significant tax burdens than expected or then need to pay in later years. Individual tax rates have been largely declining for three decades, while few experts believe tax rates will be lower in the future.

In theory, if a sleeve of income-earning bonds or high yield bonds is part of an investor’s overall allocation, should these holdings be held in an individual’s taxable or tax-deferred account? Why does it matter? What is the cost differential if done improperly?

Here’s a frequent example of mine that has to do with my favorite hypothetical company, XYZ:

  • Investor A has a $1 million investment in company XYZ, with a zero-cost basis, held in a tax-deferred IRA savings account. 
  • Investor A also has $1 million directly invested in company XYZ stock in their personal trust or investment account, also with a zero-cost basis. 

On paper, both assets are worth the same—except for the significant difference in future tax liability. And if the client dies with a substantial IRA, the tax burden on future generations may even be higher. 

The obligation of the tax-deferred IRA is set at the income tax rate, which could currently be over 40% or higher if ordinary income tax rates increase again. But the sales of stock in a taxable account would be subject to a much lower long-term capital gains tax–less than 20%, even for the highest income investor. 

Assuming a zero-cost basis for this hypothetical example, the IRA investment could have an estimated $600,000 after-tax value, while the stock investment in a taxable account could be worth as much as $800,000. Some would call this found money, but in reality, it’s a conscious choice to weigh long-term risks and benefits. If an investor is blinded or distracted by the allure of tax deferrals, they may miss out on the opportunity to have greater flexibility for future earnings.

I don’t believe that tax-deferred plans are inherently unhealthy, though the late Sy Syms said, “An educated consumer is our best customer,” and the same may be true in the realm of tax deferral. 

At the end of the day, all we’re saying is, why should one pay more taxes than they need to after all?





(Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.)