Why Your Retirement Account COULD Become A Lot More Valuable If Hillary Clinton Becomes President
By Jeffrey Levine, IRA Technical Expert
Follow Me On Twitter: @IRAGuru4EdSlott
Retirement accounts are pretty awesome when you think about it. Not only do you typically get a break on your current tax bill for making a contribution to your IRA, 401(k) or other retirement account (though not with a Roth account), but you can watch those contributions grow for decades without ever being eroded by taxes. This benefit, which is more formally known as “tax deferral,” can allow you to build significantly more wealth over time than if you were to make the same investments outside of a retirement account. Consider the following:
Mary makes a $5,500 contribution to her IRA every year from the time she is 30 until she is 65. Over that span, she earns a 7% rate of return. By the time Mary is 65, she’ll have contributed $192,500 to her IRA, and her account will have grown to over $760,000.
Doug, on the other hand, puts $5,500 into a “regular” non-retirement account each year, for the same 35 years as Mary. He also earns 7% each year, but his earnings consist entirely of interest and short-term capital gains (gains from investments that are held for one year or less), both of which are taxed at ordinary income tax rates. Assuming Doug is in the 25% ordinary income tax bracket and pays his taxes out of his investment account, he’d have about $525,000 in his account when he turned 65. That’s pretty good, but it’s also a lot less then Mary would accumulate over the same time frame.
Sally also puts $5,500 into a “regular” non-retirement account each year, for the same 35 years as Mary. She also earns 7% each year, but her earnings consist entirely of qualified dividends and long-term capital gains (gains from investments that are held for more than one year), both of which are taxed at preferential long-term capital gains rates. Assuming Sally is in the 25% ordinary income tax bracket, she’d owe 15% on all of her capital gains. If she were to pay her taxes out of her investment account, she’d have about $606,000 in her account when she turned 65. That’s much better than Doug, but it’s still a far cry from Mary’s total.
From these three examples, it’s not hard to see how tax-deferral can help you accumulate more money for your retirement. It’s also stands to reason then, that the higher your tax rate, the more powerful tax deferral is.
Note: This examples ignores the income tax consequences of taking a distribution from Mary’s retirement account vs. Doug or Sally’s account. Although her $760,000 would be taxable, while their accounts would be after-tax, Mary presumably would have been receiving tax deductions for her IRA contributions for 35 years that could have also been invested. A more thorough comparison of these outcomes is beyond the scope of this article. But if that’s still going to hang you up, just imagine that Mary’s traditional IRA is a Roth IRA. Now, all three of the balances in our example are after-tax, and the only reason Mary’s balance is higher is because of her tax deferral.
So what does any of this have to do with Hillary Clinton becoming President? Here’s the deal.
Although there are still more unknowns than there are knowns at this point, media outlets have widely reported over the past few days that as part of Clinton’s tax plan, she would propose making significant changes to the current capital gains structure. As noted earlier, short-term capital gains – gains from investments that are held for one year or less – are generally taxed at ordinary income tax rates. These rates are currently as high as 39.6% (43.4% when you factor in the 3.8% surtax on net investment income). Conversely, investments that are held for longer than one year are generally eligible to be taxed at more favorable long-term capital gains rates. The long-term capital gains rate for most Americans is 15%, but for high earners, the rate can be as high as 20% (23.8% when you factor in the 3.8% surtax).
Regardless of a person’s income though, there is no tax incentive to hold onto an investment for longer than one year (other than, perhaps, a step-up in basis if you hold the investment until you die). If you’ve held an investment one year and a day or you’ve held it for 25 years, the tax treatment you’re entitled to is exactly the same.
According to Clinton’s aides, this is something she plans to challenge as part of her platform. As reported so far, Clinton’s plan would not change the tax structure for investments held for a year or less, but would create a new sliding scale of sorts for longer-term investments. For instance, it’s been floated that Clinton will propose raising the capital gains tax for investments held for only two or three years to at least 28%.
Anytime the capital gains tax rates – or the ordinary income tax rates for that matter – go up, retirement accounts, due to the tax deferral they provide, become more valuable. It’s that simple. So if Hillary Clinton is eventually elected President, there’s a reasonable chance that your retirement account could be worth even more to you in the coming years than it is today.
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