Why IRA and Keogh Plans Should Avoid Growth Stocks
Frank J. Fabozzi
EDHEC Business School
The Journal of Financial Research, Vol. 8, No. 3, pp. 203-215, Fall 1985
This theoretical paper seeks to correct a common error about the effect of personal taxation on the expected pre-tax return earned on equity portfolios held by mutual funds in tax-sheltered retirement plans such as IRA and Keogh (401-k). Contrary to the prevailing view, the analysis reveals that the pre-tax return on a stock is inversely related to its per-share growth rate. The explanation for this effect does not rely on the false assumption that growth decreases the effective rate of taxation. Rather, this effect holds despite the heavier taxation of growth stock - because of the incomplete manner in which the return is sheltered. This finding has important implications for the optimal equity portfolios held by tax-sheltered pension funds. Most immediately, this finding is inconsistent with the frequent practice of such funds of concentrating in growth stocks or recommending them to their clients. A second issue examined is the use of IRA and Keogh plans as a temporary tax shelter. Under the present penalty of 10 percent imposed on premature distributions, the minimum beneficial sheltering period may be as short as two-to-three years. This indicates the potential attraction of such plans as a general investment tool.
Keywords: investment for retirement, pansion plan, tax-sheltered stock portfolio, growth vs. income stocks
JEL Classification: G11, G12, G18, G23, G28, H24, J32, J38Accepted Paper Series
Date posted: February 19, 2008
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