What’s the advantage of tax-advantaged accounts?

On Sunday I wrote about what I consider a fairly important oversight in the world of financial independence enthusiasts: a glaring disregard for just how minimal the taxes they spend so much time avoiding really are. Capital gains harvesting, for example, is the practice of realizing long term capital gains as often as possible in order to pay minimal taxes on the proceeds. That’s all well and good, and perfectly legal and whatnot, but for the overwhelming majority of investors it’s also completely unnecessary.

However!

I don’t want that to shade into saying that tax-advantaged investment accounts don’t have advantages. They do, but they’re somewhat orthogonal to the ones people generally emphasize. So today I want to spell out the advantages tax-advantaged accounts really do have.

Internal tax-free compounding

Once funds are invested in a tax-advantaged account, whether it’s an IRA, 401(k), 403(b), 529, HSA, or any other vehicle that suits you, they have the great advantage of offering internal tax-free compounding: instead of owing taxes, however minimal, on dividend and capital gains distributions each year, those distributions can be reinvested (or not) within the account without incurring any income tax liability.

It is treated as an article of faith that this feature of tax-advantaged accounts is an unalloyed good and a key to increasing your net worth, achieving financial independence, and all the other things to be mined from the Big Rock Candy Mountain. Since I take money literally, I have to break it to you that it’s just not so.

Consider an account holding $10,000 in a mutual fund paying a 2% annual dividend. Actually, let’s be rich people, and hold $1,000,000 in a mutual fund paying a 2% annual dividend. In a taxable account, we’ll earn $20,000 per year in dividends and owe the maximum marginal capital gains tax rate of 23.8%: the maximum 20% long term capital gains tax rate plus the 3.8% net investment income tax.

This, all things considered, sucks. $4,760 of our annual dividend goes straight to Uncle Sam and his bizarre effort to provide health insurance to the working poor.

Now consider the case of the millionaire who, thanks to frequenting financial independence blogs and forums, has managed to squirrel away the whole million into a Roth IRA. Each year the investment spins off $20,000 that he’s able to reinvest tax-free, thus realizing the dream of internal tax-free compounding.

The question is: what does he do with the $4,760? I have never met anyone who looks at their tax-advantaged investment accounts each year, calculates the amount they saved by avoiding the federal capital gains tax, and then invests that amount. In the past I’ve called that “compounding discipline,” and no one has it. You don’t have it, I don’t have it, no one has it.

Make decisions without tax consequences

Friend of the blog Alexi over at Miles Dividend M.D. has explained his adoption of Gary Antonacci’s “dual momentum” investment strategy, whereby you invest in domestic stocks, foreign stocks, or cash, depending on which has performed best over the last 12 months (I’m not doing the strategy justice, for obvious reasons).

While such strategies may not trade “frequently,” they certainly trade more frequently than “buy and hold forever,” which is my preferred strategy. If you’ve been convinced that such a strategy will best serve your financial interests, you’ll be much better off pursuing it in a tax-advantaged account than in a taxable account where moving in and out of funds will incur annual short-term capital gains, taxable at your marginal federal income tax rate.

While such strategies are an extreme case, there are other reasons you might want to make investment decisions without tax consequences. When I took control of my IRA, it was invested in a number of funds which I simplified into a Vanguard target retirement date fund. Several years later, as I learned more about investing, I simplified it further into the Vanguard 500 fund. I have yet to hear a compelling argument for doing so, but someday I may simplify it even further into the Vanguard Total Stock Market fund. These aren’t market timing decisions, but simply the natural course of my investing education, and I’m certainly grateful not to have incurred any taxes or even significant paperwork along the way!

Manage adjusted gross income

While it isn’t applicable to everyone, the ability to use pre-tax retirement savings vehicles to manage your reported adjusted gross income can sometimes provide an outsized return on investment. It’s why I earn $18,500 every year, for example. Other than the reasons explained above, I do not generally think that it’s worthwhile aggressively managing your adjusted gross income, unless you are able to bring it below a threshold that triggers special tax benefits (these benefits shouldn’t exist, but as long as they do I understand and share the impulse to game them).

Lock in today’s tax rates

Finally, I’m not trying to ignore the elephant in the room: assets that can be shielded in Roth IRA’s and Roth 401(k)’s, and withdrawn in retirement, will never be taxed again. The same is true of 529 college savings plans when the funds are spent on qualified higher education expenses. Such accounts give you access to internal tax-free compounding, reallocations and reinvestments without tax consequences, and tax-free withdrawals.

It’s no secret that I believe capital gains should be taxed as ordinary income (perhaps with an inflation deflator if held for a long enough period), but if that dream ever becomes a reality, then people with the foresight to seize every possible opportunity to shift their investment balances into after-tax Roth accounts and tax-free inheritance vehicles will surely be laughing at all the suckers who figured that long-term capital gains taxes were too low to bother shielding their investments from it.

Conclusion

There are reasons to contribute to tax-advantaged investment vehicles, particularly after-tax and never-taxed vehicles like Roth retirement accounts and 529 college savings plans. But if you don’t know why you’re doing something, you’re vanishingly unlikely to be doing it for the right reasons. So before harvesting your losses, harvesting your gains, or harvesting your artichokes, be sure it actually makes sense for your situation.