When Tax Shelters Backfire

By Rick Ashburn

Like anyone else, I like a good tax shelter when I can get one. Among the beauties of a tax system that is tens of thousands of pages long is that there is a little something in there for everybody. The downside to this Byzantine system of regulations is that a fast-talking salesperson can convince us to take advantage of a tax shelter that is not really sheltering anything.

The most obvious examples of attractive tax shelters are IRA accounts and 401(k) plans. We put money in and it grows tax-free. We only pay tax on it when we take it out. The money is not only growing tax-free, it has been deposited in the account tax-free. A double benefit.

Other forms of tax-sheltered investing can also allow your money to grow tax-free. However, these other investment vehicles require you to pay taxes on the money before it is deposited. You then pay tax on the profits when you draw the money out. The most popular way to do this is with variable annuity products that insurance and brokerage companies sell. Upon first review, these ideas seem to make sense. The money grows tax-free, meaning faster, and is only taxed when you need it.

When evaluating any investment or tax strategy, we are wise to compare it to alternatives. After all, no strategy is perfect in and of itself. It is only better or worse than its alternatives. The alternative to placing after-tax money into a variable annuity is to simply invest it in stocks or a stock mutual fund. We should compare how these two scenarios play out over time, say 20 years.

Since the invested money is after-tax either way, let’s assume we invest $100,000 on which we have already paid taxes. Each strategy allows us to invest in stocks.

For the variable annuity account, we can ignore annual taxation – there will not be any. For the standard mutual fund account, we make some simple assumptions. First, we assume that 90% of all capital gains are long-term, and that the portfolio turns over at a 20% annual rate, producing capital gains. Each of these assumptions is reasonable for an indexed or tax-managed mutual fund account. At the federal capital gains and dividend tax rates, the brokerage account is subject to a federal and state tax rate of 26.3% on the capital gains actually realized each year, plus a 24.3% tax on dividends. Some of the investment income in the mutual fund account is lost every year to taxes, rather than reinvested. It grows more slowly, on paper, than the variable annuity.

But, let’s now skip out 20 years. We need the money for retirement or to pay for our kids’ college. We now see the defining difference in tax rates for these two investment strategies. The mutual fund account can be liquidated in full, and all remaining untaxed profits are taxed at 24.3%. By this time, we have already paid tax on about 80% of our cumulative gains and income over the years, so our tax bill is rather modest.

The variable annuity account has never been taxed, and 100% of its gains and income are now subject to tax. And, here’s the rub. The gains will be taxed not at the 24.3% rate of the mutual fund account, but at the taxpayer’s marginal income tax rate. For many retiring Californians, that will be a 46.3% combined tax rate. The money grew faster in the sheltered product, but is taxed more heavily in the end. Which effect wins?

Assuming an annual stock portfolio return of 7.75%, our variable annuity will produce an ending after-tax balance in 20 years of $292,000. This ignores the additional fees, costs and commissions of the insurance company. The mutual fund account will produce an after-tax balance of $319,000, using the turnover assumption of 20% per year. Even if the mutual fund account were turned over at a rate of 100% per year, it still results in a higher ending balance of $306,000.

This result is due to the very simple fact that investment income that would normally be subject to a low 15% federal tax rate is instead taxed at 25% to 37% if earned in a tax-deferred investment product. While tax deferral will allow the money to grow faster, the very heavy tax hit at the end more than wipes out any advantage.

Not all tax shelters are what they seem. It is sometimes a wiser strategy to pay a little tax now than to pay a lot of tax later.