The Legislative Bias Against Saving
My partner and I recently decided to start saving to build a new home in 10 years or so. I’ve been saving for my retirement via a 401k plan for some time, but saving a significant sum for a shorter-term goal is fairly new to me.
Since we have an investment horizon of 10 years and the flexibility to wait a few years longer if we need to, it makes sense to invest in stocks or mutual funds to get the greatest return. I’d rather not have to monitor my investments daily, so I started my research by focusing on mutual funds. After all, I’ve been investing successfully in my 401k plan’s mutual funds for nearly 10 years already, and it seems simple enough.
I soon discovered that investing in mutual funds for anything other than my retirement is going to be much more complicated because of the tax laws. There’s no tax-sheltered account for saving for a house or any other goal not specifically approved by the government. If I invest in mutual funds in a taxable account, I have to take a whole new set of variables into consideration:
- When my fund makes a distribution I’ll be taxed on it. If I’m unfortunate enough to buy a fund right before a distribution, I’ll be getting taxed on gains I didn’t realize! It’s important to find out when the fund makes distributions to avoid this.
- When I sell my fund shares I will have to calculate my cost basis for tax purposes. If I only purchase the fund one time and it never makes a distribution, this is easy. Typically, though, I’d be buying more shares over time and reinvesting the distributions. This complicates things considerably.
- Funds with low turnover ratios tend to be more tax-efficient, so I need to look for that. Morningstar will show you tax-adjusted returns for a fund, which can be helpful, but there’s no guarantee your fund will behave the same way in the future.
Those are just a few of things you need to be aware of when buying funds in a taxable account. Stocks are a little different ‘“ you get direct control over the timing of your capital gains in return for micromanaging your investments, but your stocks may still pay taxable dividends. Bonds are different too, because some are taxable and some are not. And then of course there’s the taxable interest from a plain old savings account.
Why does this have to be so difficult? Shouldn’t the laws make it easy for people to grow their wealth?
Sure, there are a few things that the government says it’s ok to save for – retirement, education, and medical care. Even if you’re going to save for one of these ‘approved’ goals though, the options can be confusing, if they’re available to you at all.
For retirement goals, you have 401k, Roth 401k, IRA, and Roth IRA. If you make too much you can’t have a Roth IRA, and the contribution limits on IRAs are pathetically low. You can only get a 401k through your employer, and your employer decides on the available investments, so not all 401k plans are created equal.
The education options make the retirement savings vehicles seem straightforward. For education you have 529 plans, Coverdells, UGMAs, UTMAs, and some people use savings bonds or IRAs for these purposes as well.
For health care, you have MSAs, which aren’t widely available, and HSAs, which have mostly made MSAs obsolete. Both of these are only available if you’ve enrolled in certain insurance plans, so if you’re uninsured, forget about saving up for health care.
For any other goals, you’re out of luck. The fact that we have savings plans where your money grows tax-free is an admission that such accounts encourage saving, or at least that we should be doing something to encourage people to save. So why are we penalizing people for saving for other goals? And why are we leaving people at the mercy of their employers for their retirement plans, or their insurance companies for their health care savings options? Shouldn’t everyone be able to contribute $14k per year to a retirement account that grows tax-free, regardless of their employer? Shouldn’t everyone be able save up for health care costs, regardless of their insurance?
So here’s what I’m getting at ‘“ we should quit taxing interest, dividends, and capital gains in all accounts. Then we can all reap the benefits that a Roth 401k would give us without having to rely on our employer for good investment options. Then we can set aside money for health care expenses and let it grow, and although it would be post-tax money at least it would grow tax-free. Then we can all save for college for ourselves or our children without wondering if the savings vehicle we’ve chosen will even exist in next year’s legislation. And even better – we can save for other goals like a house, a car, a vacation, or starting a business, just as we currently can for the government-approved savings goals. Saving for big goals should be easy by default – tax-free accounts should be the rule, not the exception.
Oh that’s right, we wouldn’t want a few rich people to get away with making lots of untaxed money off investments. Even Warren Buffett has criticized the 2003 tax cuts on dividends and capital gains. That’s easy to do when you’re a billionaire, but maybe the rest of us could use some encouragement in the form of a simpler tax system.
Most government debt has tax free interest payments. Granted the yields a slimmer than commercial (read: taxed) paper and any gains realized from sale before maturity are also taxed.
And yes, there is a legislative bias against saving in the US. It was a product of the Marshall Plan post WWII to induce spending. If income from investing is taxed, people will spend more than save. Countries with high savings rates have the inverse scheme – postal savings accounts in Japan have tax free growth.
To be fair, you will be taxed much less on what you make investing than on what you would make if you earned the income through working. Long-term capital gains are only taxed at 15% whereas your marginal tax rate is likely much higher from your income.
Perhaps the real question is why is the Federal government taxing earned income more than investment income.
It’s fair to say that the investment tax system is complicated, but it is mostly complicated in ways that benefit investors. (It may seem like a pain to calculate your basis but it certainly beats paying tax on everything other than what you put in at the rate you pay taxes on your earned income.)
Why do rich people pay less tax on their unearned income than regular people do on their earned income?
Yet another reason why the FairTax act would be a good thing for this country….not to mention the money that would pour back in from offshore bank accounts and other tax shelters. We would get loans at much better rates and our investments would always grow tax free.
Your brand spanking new house would have a sales tax, but most of those taxes are already built into that new house anyway.
My partner and I are real estate investors and we are always making decisions based upon the tax outcome. It is too bad we can’t make decisions based upon what is the best thing to do.
Well to begin with most Mutual Funds (I know Vanguards do for sure) keep track of your Cost Basis for you so figuring it for Tax Purposes is easy.
However have you considered what is called a Tax Managed Mutual Fund?? Vanguard has I believe 5 different ones. The funds have the objective of Minimizing the amount of Tax you pay each year.
You don’t get quite the same return as a regular fund but it can offset gains in others.
~ Roland
Thanks for the great comments!
To Josh: I alluded to municipal bonds when I mentioned that some bonds are not taxed, though I didn’t go into detail. That’s an interesting point about the Japan accounts. I know the Cato Institute has a proposal for general-purpose tax-free savings accounts, but I ignored that proposal here because I think it’s too limited (and adds yet another special type of tax-advantaged account).
To Phil: I agree. I’d love to see the Fair Tax or similar replace our whole mess of an income tax system.
To WTTO and FrugalZen: Good points. My main goal here was to draw attention to the fact that the tax code promotes saving for certain goals by certain means, but not just saving in general, which is unfortunate.
While I agree there is room to simplify the tax code and think paying taxes on unrealized gains doesn’t sit right with me, I have to disagree with the overall premise. Why should earned wage income be the only type taxed? The incentive to save is that you can earn interest and buy something that you want flat out, instead of paying the price plus interest by financing or going without what it is that you want. But that doesn’t excuse you from paying your fair share for services.
Encouraging education and retirement have clear, widespread public benefits so forgoing tax revenue (which has to be made up by higher taxes or reducing services) can be justified to an extent.
But if I’m investing in real estate properties, I’m increasingly depending on government to provide services in order to ensure the safety of those investments. Those investments make me more money when the schools are safe and good, when police ensure safety, when the water flowing to them is clean. If I’m investing in companies, I’m counting on the government to ensure they are in compliance with the law, that they are safe places for their employees, that the education system is feeding innovative minds to them. In both scenarios, I have a greater stake in the government’s services to those investment vehicles than someone who has not invested in them, thus it makes sense that I would pay taxes on the income I make on them to fund those services.
As for savings accounts, they’re insured up to $100,000 by the federal government- so really the taxes serve as a premium. I have no objection to paying the premium on any other kind of insurance that I have.