Dumb question about taxation of IRA withdrawals

[md-2000]

@Hari_Seldon

I once figured this out. I am in Canada, but the rules are much the same. The fact that your income on the investments are not taxed immediately but reinvested overwhelms the difference between paying capital gains taxes yearly and ordinary income taxes many years later.

@andrewm

No, all other things being equal, it doesn’t make any difference. Wether you are taxed in the way in or the way out, the result is the same. Look at an example of someone with a 20% tax rate who gets a 5% return for 40 years:

Traditional: $5000 invested for 40 years with 5% return: $35,200 - after tax, $28160
Roth: $4000 invested for 40 years with 5% return: $28160

What matters is if your tax rates during the contribution and withdrawal phases are significantly different. If you believe you will have a lower tax rate when withdrawing than when contributing, Traditional makes sense. Otherwise, Roth wins.

@RitterSport

For most fund investments, you’ll have realized taxable gains along the way, eating away at your return. So, year one, you earn 8%, but only 6% after taxes to get reinvested, etc. Those gains along the way get taxed at a lower capital gains rate, of course, but it’s a drag every year.

In an IRA, all taxes are deferred and the full amount can be reinvested each year.

The key point being, too, that your gains would be taxed each year outside a savings account. So (simplified numbers) if your (re)investments make 5% and tax is 20% (1/5) then the net gain on your investment each year is only 4%. Compounded. Even with 15% tax your growth is less.

Plus, with tax-free contributions, you start 20% ahead. I think 20% at the end is better with 5% growth than 20% pay-as-you-go with 4% growth. The longer your (re)investments go on, the further aheader you are. As I understand, you are continuing to grow tax free until the fund is exhausted, so possibly into your 90’s…

[Munch]

@md-2000

The key point being, too, that your gains would be taxed each year outside a savings account.

No, only your realized gains are taxed.

[Machine_Elf]

@Munch

No, only your realized gains are taxed.

In addition to realized capital gains being taxed when you sell the asset, qualified dividends are taxed (at the cap gains tax rate) in the year in which they are paid out.

Qualified dividend

[We_re_wolves_not_werewolves]

Even an S&P 500 fund will throw off yearly dividends, which are then taxed, even if you reinvest those dividends. This is known as the “tax drag” of a taxable brokerage account and it makes a difference. The tax deferred aspect of an IRA/401k is very valuable, especially over many years.

[md-2000]

@Munch

No, only your realized gains are taxed.

True. So I guess it depends on your investment strategy, how often you buy and sell. Do most people simply buy a pile of stocks and leave them for 20 years? most of the less savvy investors tend to buy those market funds, which IIRC generate income every year., taxable if not in a registered fund.

I know I was in a company-sponsored fund that was not registered tax-free, and there was the one year (in the dot-com boom?) where a number of us were hit with several thousand dollars or more in extra taxes from the fund. (The fund managers made provisions for us to pay out of the fund itself)

[We_re_wolves_not_werewolves]

@Munch

No, only your realized gains are taxed.

This is technically true but misleading. If you are talking about selling funds or stocks, then you are correct that you do not pay taxes until you make that sale. However, as I mentioned in another post, and as noted by Machine_Elf, dividends are considered realized as soon as they pay out, even if you reinvest the dividends and do not withdraw them from the account. And almost all funds pay some dividends (e.g. an S&P 500 fund will pay out about 1.5% per year). Individual stocks may or may not pay dividends.

[md-2000]

@We_re_wolves_not_werewolves

Even an S&P 500 fund will throw off yearly dividends, which are then taxed, even if you reinvest those dividends. This is known as the “tax drag” of a taxable brokerage account and it makes a difference. The tax deferred aspect of an IRA/401k is very valuable, especially over many years.

I was under the impression that these funds were regularly buying and selling stocks to rebalance the fund according to the current market, which I assume would also create realized income. Or is it that the income to the investor is only realized if they sell their shares in the fund?

(Can you tell I’m not deep into this stuff?)

[Munch]

@md-2000

I was under the impression that these funds were regularly buying and selling stocks to rebalance the fund according to the current market

Yes and no. They have to maintain a benchmarked “mirror” to their index - but a lot of that can be done through the daily buy/sell from the investor pool.

Additionally, if someone is extremely tax-averse for a non-qualified account, there are tax-managed mutual funds that track the S&P 500 but employ strategies to minimize any tax issues (strategic buy/sells, etc.). Some people will just buy Berk.B, which has been a very close approximation of the market for years, and has no dividends or interest.

[We_re_wolves_not_werewolves]

@md-2000

I was under the impression that these funds were regularly buying and selling stocks to rebalance the fund according to the current market, which I assume would also create realized income. Or is it that the income to the investor is only realized if they sell their shares in the fund?

the buying and selling of stock done by the funds is not imputed income to the investor (you). So yes, you only realize income from the price increase of the fund when you sell it. But as noted, any dividends thrown off by the fund will be considered income as soon as they are disbursed to you, and you will need to pay cap. gain taxes on those dividends yearly.