An Analysis of the Tradeoff between Tax Deferred Earnings in Iras and Preferential Capital Gains

Abstract

This paper extends prior research in evaluating the decision of whether to invest in a mutual fund either outright or through one of the three available IRAs: the deductible IRA, the Roth IRA, and the nondeductible IRA. We provide mathematical models for after-tax accumulations for each of the investments that are a function of return, the percentage of the return currently taxable to the investor, the time horizon of the investment, the capital gain tax rate, and the ordinary income tax rate. The Roth IRA and the deductible IRA always dominate investments in the nondeductible IRA or through outright investment. However, in comparing the nondeductible IRA and outright investments, the outcome is dependent on the investment goals of the mutual fund and whether it generates substantial dividend distributions or capital gain distributions. Mutual funds with small dividend and capital gain distributions may accumulate larger amounts if held outright while mutual funds that pay substantial dividends or make substantial capital gain distributions accumulate larger after-tax amounts when invested in a nondeductible IRA.

JEL Classification: G11