Afraid to invest during the invasion of Ukraine? Try This IRA Maneuver
Moe, Larry and Curly have seen stock markets plunge over the past two weeks in response to the Ukraine invasion. Each wants to invest, say, $100,000 in European stocks, for example through Vanguard’s European Stock VGK,
ETFs – because they think prices have gone down so far, they look like a bargain.
But this is where they disagree.
Moe thinks he should make the investment using his usual after-tax brokerage account. He believes that this way he will only pay favorable capital gains tax rates on all profits, rather than higher income tax rates. And if he loses money, he can deduct it from future income tax.
Larry thinks he should invest in his individual Roth retirement account after tax. He thus thinks that his future earnings will be completely exempt from tax.
And Curly wants to make the investment using his traditional pre-tax IRA – even if he makes a profit, he’ll end up paying high ordinary tax rates on any gains, and those are usually higher than capital gains rates.
So Moe and Larry are the smart guys and Curly is the model, right?
So much of the conventional personal finance wisdom says.
But the CW could be wrong.
In fact, in this case, there’s an argument that Curly might be making the really smart choice.
Read: Worried about inflation? This is how investments did in the 1970s
Before I go any further, let me lay out the tedious but important disclaimers, lest I get angry emails from the kind of person driving on the freeway (at the start of Memorial Day weekend) at 54 MPH. No, there is no definitive answer. Yes, there are several assumptions and moving parts. We don’t know if the equity fund will continue to fall or if it will start to rise (and, if so, when). We don’t know what tax rates our friends are paying now, or what they will pay in retirement. We don’t know what will happen to marginal tax rates. etc Keep all of these caveats in mind. Besides, the past is no guarantee of future results, global stock markets could enter a 100-year bear market tomorrow, or the world could end.
But here’s why Curly’s move isn’t as dumb as it looks.
Contrary to what they seem to think in the personal finance school of theory, we don’t actually know if, say, European stocks (or any stocks) will go up and up from here. If we did, investing would be really, really easy. Investing always involves an element of gamble.
But because he’s investing with pre-tax money in his traditional IRA, Curly is taking part of his bet. with other people’s money.
Those other people? Uncle Sam or, more specifically, other taxpayers, like you.
Curly paid no tax on his money before putting it into his IRA. And he won’t have to pay anything on it unless he makes a profit.
Meanwhile, Moe and Larry gamble with after-tax dollars. They have already paid tax on the money no matter what happens to their investment. They had to earn $120,000 (or $150,000, or whatever) in their pre-tax job in order to have $100,000 left to bet. So even if their investments fail, they lost that tax money.
Anyone who has followed Wall Street long enough knows that one of the key secrets to getting rich in the markets – perhaps the key secret – is to play as much as possible with other people’s money. Tails you win, tails someone else loses.
Curly, the only one of our three friends, plays with OPM.
And while yes, he’ll likely pay higher taxes than others if the bet pays off, that may be a rational trade-off. He can understand that his #1 goal in retirement is not to die as rich as possible, but to minimize the risk of running out of money when he’s old. He may therefore be willing to accept higher progressive taxes if he does bank in exchange for the promise of much greater tax relief if he does not.
Oh, and the clever Curly also has a second way to win here.
Let’s say the markets continue to fall, the investment crashes and loses, say, 50%, so the original $100,000 stake is reduced to $50,000.
Curly can take advantage of the plunge… by converting his traditional pre-tax IRA to an after-tax Roth. Of course, he will have to pay ordinary income tax upon conversion. But after investing $100,000 of the pre-tax money, he will only have to pay income tax on the converted $50,000. And now, if his investment goes up, all the gains are completely tax-free in a Roth.
Heads he wins, tails he wins.
Moe or Larry? They’re out of luck.
Larry, by investing with his Roth, has no possibility of tax relief if his investment goes down. His tax money went to money heaven and never came back, even though he lost half of what he had left.
Moe, who used his taxable account, isn’t much better off. Technically, he can claim his $50,000 losses against other capital gains. But that assumes he has other capital gains. And while he can claim any remaining losses on his annual tax bill, he is limited to claiming only $3,000 of those losses per year.
It is a derisory sum. Congress set the limit decades ago, but never updated it with inflation. (If you were a wealthy hedge fund manager, of course, that would be another matter. You’d get the cherished tax deal known as the “deferred profit-sharing loophole.”)
At the end of the line ? Conventional wisdom says to take your biggest bets with after-tax money. But conventional wisdom isn’t always right.