Mitt Romney may have made the classic IRA mistake: holding low-tax investments inside a tax-favored account. His IRA strategy isn’t clear, of course. Romney continues to guard his personal finances. But details are trickling out, and even if it turns out that Romney’s traditional IRA is built right for him, the securities he holds in it serve as a valuable reminder that not all investments belong in a tax-favored account.
Romney’s IRA is valued at between $20.7 million and $101.6 million, according to The Wall Street Journal. That’s an extremely wide range that the Journal found in Romney’s latest financial disclosure report, filed in August. His IRA produced income between $1.5 million and $8.5 million last year.
So he’s not like most of us, financially speaking. But he is exactly like us in that he has limits on how much he can contribute to an IRA, or to a 401(k) plan that can be rolled into an IRA. Given those limits it’s remarkable that he has been able to amass such wealth in a tax-deferred account.
For most of his years at Bain Capital, the annual IRA pre-tax contribution was capped at $2,000 and the annual 401(k) pre-tax contribution, including employer match, was capped at $30,000. Other limits are in force today: $5,000 for an IRA ($6,000 if you over 50); $16,500 for a 401(k) ($22,000 if you are over 50).
Assuming Romney was maxing out pre-tax contributions, as should anyone who can afford to do so, he still would have needed extraordinary returns within his tax-deferred accounts to build such a big balance. He must have been investing in stocks and other high-growth potential vehicles, which produce a capital gain.
Here’s the rub: The max capital gains tax is just 15%. That’s what Romney would pay in federal tax upon selling his stocks from a taxable account. Yet when Romney begins taking distributions from his IRA, as he must in his 71st year, the money will be subject to federal income tax at rates of up to 35%. That tax-rate disparity is why it often makes sense to hold stocks in a taxable account and things like real estate investment trusts, rental properties, bonds and other income-generating investments in an IRA or 401(k). This is especially true for the wealthy, like Romney, whose net worth is about $250 million. Rich people have ample resources to max out tax-deferred vehicles with bonds and hold their stocks in a taxable account—all while maintaining a desired asset allocation of, say, 60% stocks and 40% bonds.
This doesn’t necessarily work with limited resources. If you only save in a 401(k) and must stretch to get the full company match, you’re probably better off with a mix of stocks and bonds in that account. Stocks also make sense in a tax-deferred account with at least 20 years before distributions begin, according a study by T. Rowe Price. And holding stocks in your IRA won’t hurt if your income tax rate will shrink when you begin to take distributions.
But, in general, it makes sense to add low-tax investments like stocks (even dividends get taxed at a max 15%) to a taxable account and income-generating investments to a tax-deferred account—especially with fewer than 10 years to retirement. A presidential candidate probably knows that. But thanks, Mitt, for the reminder.