Did I say mandatory? I meant optional! You’re “free” to die in a cardboard box under a freeway as a market capitalist scarecrow warning to the other ants so they keep showing up to make us more!
Dividends paid out to taxable accounts are taxed.
Dividends that pay into non-taxable accounts can accumulate until they are withdrawn.
So, for instance, if you own $100 of Exxon in a regular brokerage account and $100 in an IRA, the $5 dividend you get from the first account is taxable but the $5 from the second is not.
This gets us to the idea of Trusts, Hedge Funds, and other tax-deferred vehicles. If you give $100 to a Hedge fund and it buys a stock in the fund that pays dividends, it never pays you the dividend on the stock so you never have to realize the dividend gain. You simply own “$100 worth of Citadel Investments” which becomes “$105 worth of Citadel Investments” when the dividend arrives.
I think dividends in a tax-exempt accounts, like a traditional IRA, are only not taxed if you reinvest the dividend or just leave it in your brokerage account. If you move money from your IRA account to, say, your checking account, that’s when you pay taxes (and there are generally fees for moving money out of tax exempt accounts without meeting certain conditions, like being of retirement age).
I think dividends in a tax-exempt accounts, like a traditional IRA, are only not taxed if you reinvest the dividend or just leave it in your brokerage account.
Right. Although, with a ROTH IRA, you pay taxes before you put the money in. Then you earn tax free even after you take it out. That makes it the preferable vehicle for long-term savings (you should expect your initial investment to double every 10 years, assuming a 7% ROI which is fairly modest - so over 30-40 years you’re saving 8x on the eventual withdrawal).
But this isn’t just limited to IRAs. Using investment funds, you can pull the same trick. Buy the fund, then allow the broker to shuffle the investments within the fund as they please. You only “earn” the money when you exit the fund, in the same way you only “earn” your retirement when you withdraw from your IRA.
Savings accounts and trusts can then be structured to be inheritable tax-free, with your heirs having access to withdraw from the fund without ever actually owning the money (and thus needing to pay taxes on the inheritance). And to make it even more squirrelly, you can borrow against these funds, which allows you to make large purchases without ever actually spending any money. This maneuver, plus a cagey use of declared loses, means you can avoid paying any tax on any investment income virtually indefinitely.
There is a big maybe on whether Roth is better than traditional IRA/401k.
My kids are at the age where they are making those bets now. So I made a hugely complicated forecasting tool to forecast which would be better.
I think it really comes down to your view on future tax rates.
Your mileage may vary.
Thanks for expanding on the finer points! With inheritance, they also reset the cost-basis when the owner dies, which means that all the capital gains accumulated over the time that the deceased had ownership is never taxed. Like, if I bought stock for $10, die when it’s worth $100, my sister inherits it, and then sells it for $110 a while later, she only pays capital gains on $10 – not $100.
I don’t think people fully realize how dramatically our tax code rewards capital, at the expense of labor, not just in the broad-strokes (like the tax rate for capital gains vs the rates for income tax brakets) but also in these little details that are easy to overlook. So thanks for the discussion!
I largely agree with all the points made here however I think the overall message is a bit misleading. I would disagree that Roth investments are the preferred for long term investments. You aren’t accounting for the opportunity cost of the taxes paid in the initial investment year. Those taxes, while small compared to what you will withdraw tax free are also losing out on 8x-ing themselves (as you would have invested that amount in a traditional tax advantaged account).
What this means is Roth is the preferable savings method if you are in a lower marginal tax rate than you expect to be in retirement. However traditional is better if you are in a higher marginal rate than you expect to be in retirement. If the marginal tax rate was the same when you invest and retire then the difference between Roth and traditional would be nil.