10/06
TRENDS AND ISSUES
www.tiaa-crefinstitute.org
effective tax rate on stocks held in taxable accounts is well above zero. Later, we will consider
individuals who will avoid paying capital gain taxes by awaiting the step-up in basis. For these
relatively few individuals, their effective tax rate on stocks held in taxable accounts may be
approximately zero. To repeat, the base case represents the vast majority of individuals who will
eventually pay taxes on capital gains and thus pay effective tax rates on stock that are well
above zero. Funds in Roth IRAs grow tax exempt as long as the Roth IRA has been in existence
for at least five years and the individual withdraws funds after attaining age 59½. What may
not be as obvious is that the after-tax value of funds in traditional IRAs also grows effectively tax
exempt. The next paragraph presents an example that may clarify this point. A more detailed
explanation is provided in an appendix and in Reichenstein (2006), an earlier issue of Trends
and Issues.
Without loss of generality, let us compare the purchasing power of $750 of after-tax funds in a
Roth IRA to $1,000 of pretax funds in a traditional IRA for someone who will withdraw the funds
when he is in the 25% tax bracket. If invested in the same asset, $750 in the Roth will buy the
same amount of goods and services as $1,000 in the traditional IRA. So, it is useful to view
$1,000 of pretax funds in a traditional IRA as if it was $750 of after-tax funds in a Roth IRA.
Generalizing, it is useful to view each pretax dollar in a traditional IRA as if it was (1-t
n
) dollar
of the individual’s after-tax funds held in a Roth IRA, where t
n
is the tax rate upon withdrawal.
The remaining t
n
is the government’s share of the current principal. Since funds in a Roth IRA
grow tax exempt, it follows that the after-tax value of funds in the traditional IRA grows
effectively tax exempt, too. For example, if the cumulative pretax return on the asset before
withdrawal is 100%, the traditional IRA’s purchasing power will double to $1,500.
In general, withdrawals should come first from the account with the highest effective tax rate,
followed by the account with the second highest effective rate, and so on. Therefore, in general,
the retiree should withdraw funds from taxable accounts before retirement accounts, i.e.,
traditional and Roth IRAs. To be more specific, in general, retirees should withdraw funds from
bonds and then stocks held in taxable accounts, and then withdraw funds from retirement
accounts. Funds should be withdrawn from bonds before stocks in taxable accounts because of
the bonds’ higher ordinary income tax rate. “Bonds” in the prior sentence, refers to all assets
whose returns are taxed at ordinary income tax rates, which would include cash assets like
money market funds, individual bonds and bond funds, and real estate investment trusts, since
REITs typically pay high non-qualifying dividends that are subject to ordinary income taxes.
2
2
There is one exception to the rule of thumb to withdraw funds from fixed-income assets before stocks when held in taxable accounts.
If the fixed-income assets are liquidity reserves—reserves that are intended to pay for unexpected bills such as a new dryer or major
car repairs—then they must be maintained in taxable accounts to serve their purpose.
TIAA-CREF INSTITUTE TRENDS AND ISSUES 6