The Real Way to Gain
Don’t let capital-gains taxes undermine your savings.

Tom Nugent is Executive Vice President & Chief Investment Officer PlanMember Advisors, Inc.
January 7, 2001, 7:30 a.m.

If I keep $0.80 on the dollar now, and after the tax-rate cut I keep $0.85, my after-tax income has increased by only 6.25%. That's not a big deal. If tax policy is going to restructure the capital-gains rate to affect individual investment decisions, there are other opportunities for changing the taxation of capital that make more sense for both the government and the investor.

First of all, the proposed reduction in the capital-gains tax rate applies only to long-term capital gains. Short-term capital gains would remain taxed at ordinary income-tax rates. The imposition of ordinary income-tax rates on short-term capital gains can be an enormous tax on profits gained from either securities transactions or sale of other property. This tax differential is unfair because there is no logical reason to introduce time to distinguish tax rates.

Investors are penalized for making a good short-term investment decision as evidenced by the fact that the government (federal and state combined) can take close to 50% of the profits. If the profit from that transaction were treated as long-term capital gains, that tax rate would fall to a high of approximately 30%. As a result of this difference, smart taxable investors will use every technique available to convert short-term capital gains into long-term capital gains.

The motive is the retention rate. The retention rate could go from 60.4% to 85%, for an increase of almost 41% in the money the investor keeps. This differential between long-term capital gains and short-term capital gains makes no sense and will introduce increased distortions into the behavior of knowledgeable investors as the difference between these two tax rates widens. Since, in most cases, the payment of capital-gains taxes is voluntary, the high tax on short-term capital gains may very well minimize government tax revenues compared with short-term gains being taxed at the long-term rate. So, under the current system, everybody is worse off. Any proposed change in the tax law on capital gains should also include doing away with the distinction between long-term and short-term.

Another insidious aspect of the capital-gains tax is the forced conversion of capital gains into ordinary income in retirement plan distributions. For investors who have either pension or profit-sharing plans that increase in value over time because of capital gains rather than dividends or interest, there is an inordinate tax burden imposed on these risk takers.

Assume that a typical retiree contributes $100,000 to a retirement plan over a lifetime and the investments in the plan provide additional capital appreciation of $400,000. Since the retiree hasn't paid tax on either the contributions to the plan or the increase in value of the plan, the "penalty" for postponing the taxation of these gains is the forced conversion of capital gains to ordinary income. So, instead of being taxed at a proposed 15% rate on any capital-gains distributions, the retiree could be taxed as high as 39.6% at the federal level on any plan distributions.

In other words, when the retiree calculates the after-tax value of his retirement savings, his $400,000 gain could be reduced to $241,600 at the maximum income-tax rate vs. being reduced to $340,000 if taxed at the new maximum capital-gains tax rate of 15%. The difference of $98,400, or a 29% reduction in his retirement savings, is significant when considering that the retiree has taken on the risk of being invested in equities in his retirement portfolio but is deprived of the reward for making such risky investments. This situation is further aggravated by the fact that any capital losses in the portfolio cannot be used to offset taxes on distributions.

For aggressive investors who plan to use growth stocks as an integral part of their retirement planning, they might be better off creating a taxable savings account outside of their retirement plan. This account could function as a synthetic retirement account and could be managed to build wealth while taking advantage of current tax law to create a unique retirement plan nest egg. If designed correctly — and assuming that future stock market returns are similar to past returns — the retiree might very well be able to accumulate wealth that is subject to only the capital gains tax.

While retirement plans such as IRAs or 401(k)'s have contribution limitations, these aggressively managed synthetic retirement plan portfolios would have no contribution limitation. Also, they would be marked to market at time of death, meaning that all capital-gains tax liability would be eliminated while, in comparison, the full value of a traditional retirement plan would be subject to ordinary income taxes. Up to half would go to federal and state tax collectors! Also, realized capital losses could provide a tax-efficient way of making annual contributions to this portfolio that could make them effectively tax-free. Therefore, the investor could very well be able to pass along substantially more assets to beneficiaries than could be derived from a traditional retirement account.

Such a synthetic retirement plan would also allow for minimally taxed withdrawals whenever the financial need arose, unlike traditional retirement accounts, which allow for early withdrawal for limited reasons only, as determined by the government.

For high net-worth individuals, the use of a charitable remainder trust could be structured in such a way as to deliver a retirement income equivalent that would be taxed at either a capital-gains tax rate or no tax at all! This strategy could provide an attractive, up-front tax deduction, flexibility in determining the timing and amount of equivalent retirement income, and the long-term benefits of building assets for a charitable gift.

Many of these techniques to reduce the penalties associated with building retirement wealth could be eliminated if the tax law on capital gains and losses were reasonably applied to retirement plan savings. The possibility of that happening is slim — so investors planning for retirement should consider various options that minimize taxes on retirement savings.