An Analysis of the Tradeoff between Tax Deferred Earnings in IRAs and Preferential Capital Gains

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This paper extends prior research in evaluating the decision of whether to invest in a mutual fund either outright or through one of the three available IRAs: the deductible IRA, the Roth IRA, and the nondeductible IRA. We provide mathematical models for after-tax accumulations for each of the investments that are a function of return, the percentage of the return currently taxable to the investor, the time horizon of the investment, the capital gain tax rate, and the ordinary income tax rate. The Roth IRA and the deductible IRA always dominate investments in the nondeductible IRA or through outright investment. However, in comparing the nondeductible IRA and outright investments, the outcome is dependent on the investment goals of the mutual fund and whether it generates substantial dividend distributions or capital gain distributions. Mutual funds with small dividend and capital gain distributions may accumulate larger amounts if held outright while mutual funds that pay substantial dividends or make substantial capital gain distributions accumulate larger after-tax amounts when invested in a nondeductible IRA.

I. INTRODUCTION

Today's financial markets provide investors with numerous investment alternatives. Not only are there many specific investments to choose from, but the U.S. income tax system adds another layer of complexity to the investment decision. With the passage of the Taxpayer Relief Act of 1997, investors now have three IRAs to invest in for their retirement. These are (1) deductible IRAs, (2) Roth IRAs, and (3) nondeductible IRAs. Deductible IRAs and Roth IRAs are always preferable to nondeductible IRAs for taxpayers who qualify for them. However, deductible IRAs and Roth IRAs are both subject to adjusted gross income (AGI) limitations, leaving nondeductible IRAs as the IRAs available for upper income individuals covered by another retirement plan.

While earnings from nondeductible IRAs accumulate tax deferred, later distributions are taxed at ordinary income tax rates. Recent increases in the ordinary income tax rate and decreases in the capital gain tax rate have raised the question of whether individuals should invest in a nondeductible IRA or make an outright investment in a mutual fund. In this paper, we hold the specific investment (a mutual fund) constant and examine the amounts an investor may accumulate in after-tax dollars in a deductible IRA, Roth IRA, nondeductible IRA, and in an outright investment in a mutual fund. The mathematical solution for the decision between the deductible IRA and the Roth IRA is straightforward. Due to greater tax incentives for the Roth IRA and the deductible IRA, the decision between either the of those investments and the nondeductible IRA is obvious. However, the comparison between the nondeductible IRA and the outright investment in a mutual fund is very complex. Therefore, the majority of our analysis is on the choice between nondeductible IRAs or outright investments. Our equations may be modified to allow pre-tax comparisons of the alternatives.

Our analysis is based on a marginal income tax rate of 31% for ordinary income, the marginal tax rate in effect for 1998 for individuals likely to invest in nondeductible IRAs, and 20% for capital gains. We provide mathematical models for after-tax accumulations for each of the investments that are a function of return, the percentage of the return currently taxable to the investor, the time horizon of the investment, the capital gain tax rate, and the ordinary income tax rate. We find that deductible IRAs and Roth IRAs are always preferable to nondeductible IRAs and outright investments in mutual funds. The choice between nondeductible IRAs and outright investments is not as clear cut and depends on the percent of return currently taxable and the investor's marginal tax rate. Our results show that nondeductible IRAs are preferred when a larger portion of the investments return is distributed as dividend or capital gain while the outright investment in a mutual fund is preferred when dividends and capital gain distributions are a smaller percentage of the total return. …