Trump’s Taxes: Can the Fox Guard the Henhouse?

October 6, 2016

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David Cay Johnston has come up with a plausible explanation of how Donald Trump used business losses to avoid paying federal income taxes. Johnston is an expert on how the wealthy use the tax code to their advantage. My aim in calling attention to this is not just to criticize Trump for minimizing his tax bills, but to raise the larger question of what kind of tax reform is needed and whether a Trump administration is likely to pursue it.

Turning business failure into personal gain

In the early 1990s, Donald Trump was the owner of failing casinos and other unsuccessful business ventures. He had borrowed and spent so lavishly that his businesses couldn’t make their loan payments and still turn a profit. Trump was like a homeowner living in a flashy mansion but going broke trying to make the payments on it. He reported net operating losses of $916 million in 1995 and was $3 billion in debt.

The operating losses had a silver lining, however. The federal tax code allowed him to use those losses to offset personal income for as many as 18 years, running from two years before the reported loss to 15 years after.

As for the debt, he got the banks to forgive almost $1 billion of it by threatening “endless litigation” if they tried to collect what he owed. Trump has boasted about his habit of paying less than he owes. “I’ve borrowed knowing you can pay back with discounts.” Many borrowers who lost their homes in the real estate meltdown would have liked that deal. Conservatives accused President Obama of “subsidizing losers” when he proposed assisting such homeowners.  Trump also got a tax break on his debt forgiveness, which would normally be considered a form of income. But Congress created an exemption that allows real estate owners to avoid this tax liability if they sacrifice future deductions for depreciation instead. (One of the tax benefits of real estate is the ability to take a deduction each year for property depreciation.) Trump had personally testified on behalf of the exemption.

Trump still had a problem, however. He still owned properties that were losing money, and they were now worth even less as investments because he had forfeited the future tax benefit of depreciation in return for an immediate tax benefit for himself. Nevertheless, he was able to sell the properties to a new stock corporation he created, Trump Hotels and Casino Resorts. The investors must have grossly overestimated the potential return, perhaps as Johnston says because they “saw gold in his brand name.” They bought the shiny image and overlooked the ugly reality. Could there be a lesson here for voters?

As the chairman of Trump Hotels and Casino Resorts, Trump was well paid whether the company succeeded or failed. He also had the company borrow more money in order to pay off his previous loans, thus saddling the corporation with what had been his personal obligations. With him in charge, the company lost over a billion dollars; the stock value plummeted, and the investors were wiped out. He walked away with millions of dollars in tax-free income, but everyone else lost–investors, contractors, and the taxpayers who subsidized his me-first business practices.

Why does it matter?

All of the financial moves I’ve described may have been legal. (Johnston does charge him with tax fraud in other contexts, but that’s another matter.) Trump’s defenders blame his economic failures on economic conditions beyond his control, justify his tax maneuvers as normal efforts to avoid paying more than the tax code requires, and praise his “genius” in achieving personal success in the face of financial adversity.

All of those claims are controversial. Rather than dispute them, I want to emphasize something else, which is tax policy. Donald Trump himself has said something like this: The tax system is rigged, but since I know the tax code so well and have brilliantly used it to my advantage, I’m the best person to fix it! Or to put it a little more whimsically, I’m the smartest fox to guard the henhouse, since I’ve been feasting on chicken for a long time!

This is a clever argument. The problem I have with it is that I see no evidence of Trump’s interest in tax reform. Democrats continue to complain loudly about his failure to release his tax returns. I wish they would call more attention to what he has released, which is at least the main outline of a tax plan. As I described it in an earlier post, it is standard Republican fare. It makes the tax code flatter and less progressive by lowering tax rates for the wealthy, and it includes new goodies like the elimination of the estate taxes that are paid by only the richest one-fifth of one percent. Surprise surprise, Donald Trump and his family stand to make a fortune from his own tax proposals. In contrast, Hillary Clinton wants to increase estate taxes and implement the “Buffet rule,” which would require those with million-dollar incomes to pay at least 30% in income taxes. I see little chance that her plan will get through a Republican-controlled Congress, but at least it’s an authentic proposal for reform.

So Donald Trump, who has cultivated the image of the populist outsider, defender of the working people, is really the protector of the rich and powerful. Hillary Clinton, the Washington insider, is really the progressive reformer. The cunning fox shows no sign of giving up his chicken dinners. If we want someone to guard the henhouse, we’d better elect a hen.

Clinton and Trump on Fiscal Policy

August 16, 2016

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I am hoping that some potential voters are still interested in hearing about policy differences between the presidential candidates. As the election campaign stands now, it seems to be mostly a debate over the candidates’ character. Does Donald Trump have the right temperament to be president? Is Hillary Clinton trustworthy? Their actual policy proposals are often overshadowed by the latest mini-scandal, what Trump said about so-and-so, or what was found in an email on Clinton’s server. I watched the CBS evening news the day that Clinton presented her economic plan, and they made no mention of it. They did, of course, do a story on Trump’s description of the President as the “founder of ISIS,” which he later said he meant sarcastically, sort of.

Meanwhile, the country faces a number of difficult policy decisions, which will remain important regardless of who wins, but on which the candidates have taken very different positions.  Decisions about fiscal policy–how to tax, how to spend–are among the most important. They affect what the federal government is able to do, and what impact it has on the economy.


Both candidates promise to accomplish things that require new spending, although they often describe their goals without trying to put a price tag on them. One goal they have tried to price out is repairing and improving the nation’s infrastructure. Hillary Clinton has proposed to spend $275 billion over five years, and Donald Trump has promised to out-build her (that’s what he’s good at) with his own $500 billion plan.

Each candidate has other initiatives that will also need funding. Clinton wants to increase federal aid to education so that students from families with incomes below $85,000 can attend state colleges tuition free. (That threshold would rise to $125,000 over the next four years.) Trump wants to put more money into strengthening the military.

The candidates differ dramatically on how they would pay for their new spending. Clinton is the more fiscally conservative here, proposing to pay for new spending with higher taxes targeted specifically at the wealthy. Trump, on the other hand, wants to cut taxes, so at least in the short run the government would face a double whammy of more spending but less revenue. (He hopes that the government would recover at least some of that revenue when his tax cut stimulates the economy; more on that later.) Trump proposes to offset some spending with reductions in “waste, fraud and corruption,” a familiar goal to be sure, but I couldn’t find any proposals for specific budget cuts on his website. He has also said that he is willing to run a larger deficit and take on more debt. He has boasted about his ability to manage debt, but we know from his business history that his methods include declaring bankruptcy and repaying debt at less than full value. At one point Trump even suggested that the United States could also shortchange its bondholders, something that the country has never done. (That could very well end up costing the country more, since it would shatter confidence in our bonds and force the Treasury to pay higher interest rates.)

So on the face of it, Clinton seems to be the fiscal conservative, and Trump the fiscal risk-taker, which makes some Republicans very nervous. However, his “borrow and spend” approach isn’t that much of a departure from what Republican administrations actually do, as opposed to what conservative orthodoxy says they should do. While Republicans sound like the ultimate deficit hawks when they are opposing Democratic spending plans, their record on reducing deficits and balancing the budget is actually very poor. Both Ronald Reagan and George W. Bush ran up large deficits by doing a lot of what Trump wants to do, increase military spending while cutting taxes.

Ever since the 1980s, Republicans have supported their tax proposals with an argument from “supply-side” economics. Tax cuts aimed at corporations and the wealthy provide more capital that businesses can use to expand, create jobs, and boost incomes. That in turn increases tax revenues, so the tax cuts don’t really increase government debt in the long run. Not very many economists subscribe to this view today, at least with regard to cuts in personal income taxes. We have had relatively low taxes on the wealthy for 35 years, and we have experienced sluggish growth and a soaring national debt. In contrast, during the great period of economic growth in the mid-twentieth century, tax rates were higher, but growth rates were also higher and deficits were smaller.

Personal income taxes

As I said, Hillary Clinton proposes to increase taxes on the wealthy. She would put a 4% tax surcharge on incomes over $5 million, in effect raising the top tax bracket rate from 39.6% to 43.6%. She would also like to make anyone with an income over $1 million pay at least 30%. Although millionaires are in the 39.6% bracket now with regard to “ordinary income,” they can pay as little as 20% on income from capital gains. That’s why Warren Buffet can point out that he pays taxes at a lower rate than his secretary. (He is supporting Clinton’s plan, by the way, even though it will raise his own taxes.) The proposal for a 30% minimum rate for millionaires was previously proposed by President Obama, and has come to be known as the “Buffet rule.”

Clinton is not proposing any major tax changes for the non-millionaire majority. Donald Trump, on the other hand, is proposing “lower taxes for everyone, making raising a family more affordable for working families.” His first proposal cut taxes so much that most analysts dismissed it as fiscally irresponsible. More recently, he has apparently adopted the plan put forth by House Republicans, at least with regard to tax rates. The details are not entirely clear because they are not yet available on the Trump website.

We do know that the Trump plan proposes to simplify the rate structure by replacing the current seven tax brackets with only three: 12%, 25% and 33%. To keep the presentation brief, I will focus on households headed by married couples filing joint returns, but the general conclusions would be true for single filers as well. Here is how the plans would affect households with various taxable incomes (after deductions and exemptions):

  • $25,000: Currently this household is in the 15% bracket, but their effective tax rate is only 11.3%, since the first $18,550 is taxed at only 10%. Their tax is now $2,822. After Trump’s simplification, all their income is taxed at 12%, so their tax rises slightly to $3,000.
  • $30,917: I’ve picked this odd number because it is the break-even point where Trump’s plan makes no difference. The household is currently in the 15% bracket, but their effective rate is 12% already, and it remains 12% in Trump’s plan. Their tax is $3,710 either way.
  • $50,000: This household is also in the 15% bracket under the current system, with an effective rate of 13.1% and a tax of $6,572. After Trump’s simplification, they are taxed entirely at 12%, for a tax of $6,000 and a savings of $572.
  • $100,000: This household is currently in the 25% bracket, but with an effective rate of 16.5%. Under Trump’s plan, they are still in the 25% bracket, but their effective rate drops to 15.2% because the first $75,300 of their income is taxed at his 12% rate. Their tax goes down from $16,542 to $15,211, a savings of $1,331.
  • $1 million: Currently they are in the top 39.6% bracket, with an effective rate of 34.2%. Trump’s top bracket is only 33%, so their effective rate comes down to 30.2%. Their taxes fall from $341,666 to $301,695, a savings of $39,970.

And so it goes. The greater the taxable income, the larger the tax reduction, not only in dollars but in rate. Like all Republican tax proposals, this one gives the greatest tax relief to the wealthy who pay the most taxes, with the aim of making the rate structure flatter and less progressive.

In addition, the Trump plan does not address the “Buffet rule,” and so it continues allowing millionaires to pay a lower rate if their income is primarily from capital gains.

The Trump plan is marketed as “lower taxes for everyone, making raising a family more affordable for working families.” But the family with a $50,000 taxable income saves $572, while the family with the million-dollar income saves $39,970. Why should the government give up badly needed tax revenue to help families that are already doing fine?

A word of caution: a complete analysis of a tax plan would have to consider more than just the tax brackets and rates. For example, the House Republican plan (and maybe the Trump plan?) also proposes to increase the standard deduction from $12,600 to $24,000, while eliminating the personal exemption. Some households, especially those without children, would see their taxable income fall. Others, especially families with two or more children, could lose more from the loss of exemptions than they gain from the increased standard deduction. I don’t think that changes my basic conclusion, but it is not simple. The candidates need to post their plans with as much specificity as possible, so that outside experts can evaluate them.

One suspects that the real objectives of the Republican plan are probably something else besides providing tax relief to the working class. Many Republicans sincerely believe that more tax cuts for the wealthy will promote economic growth, although doing that from the top down is a dubious proposition. Democrats are more likely to believe that government spending on useful job-creating projects is a more direct path to growth. The difference is even starker, since some Republicans have advocated tax cuts specifically to deprive the federal government of revenue in order to keep government small and weak, “small enough to drown in a bathtub,” as anti-tax crusader Grover Norquist has put it. As far as I know, Donald Trump has not made that argument. He really can’t, since he is promoting increases in both military and domestic spending. But it may be an objective of House Republicans, who could be very influential in a Trump administration. They do want to reduce domestic spending, although they have to be careful about how they present that to the public. Better to speak of “entitlement reform” than “cutting social security benefits”; better to speak of “reducing dependency on government” than “taking away food stamps from hungry children.” Surveys have found that Americans like the idea of limited government in the abstract, but rarely rally around when specific programs are on the cutting board.

A presidential campaign should be an opportunity to have an honest, fact-based debate over fiscal policy, among other things. Right now, that’s just not the kind of thing that get’s voters’ attention.

In the next post, I’ll discuss differences between the candidates on estate taxes and corporate taxes.


Rewriting the Rules of the American Economy (part 2)

March 10, 2016

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The central message of Stiglitz’s latest book is this: “The American economy is not out of balance because of the natural laws of economics. Today’s inequality is not the result of the inevitable evolution of capitalism. Instead, the rules that govern the economy got us here.”

We have been operating under a set of rules that were inspired by the largely discredited “supply-side” economics. The aim was to free up capital by cutting taxes, regulation, and wasteful social spending. That would promote more investment and economic growth, with the benefits flowing to all levels of society (what critics call “trickle-down” economics). This was in contrast to the traditional Keynesian approach preferred by liberals, which stressed the importance of maintaining aggregate economic demand through government spending beneficial to the middle class and the poor. Stiglitz and his co-authors regard the supply-side approach as a failure. “These policies increased wealth for the largest corporations and the richest Americans, increased economic inequality, and failed to produce the economic growth that adherents promised.”

Greater wealth at the top does not necessarily translate into greater productive capacity for the economy. Wealth becomes capital only when it is invested in productive activity, but wealth that is not so invested can still produce an economic gain. Property owners in a hot real estate market can collect rents and/or capital gains without making anything or creating any jobs. If the rules of the game encourage it, those with wealth and power will devote too many resources to “rent-seeking,” that is, “obtaining wealth not through economically valuable activity but by extracting it from others, often through exploitation.” The rule changes inspired by supply-side economics shifted the balance of power toward the wealthy and made it easier to make money without serving society very well.

Deregulation of industries such as airlines, railroads, telecommunications, natural gas, and trucking, as well as legal rulings limiting regulation in general, made it easier for big companies to accumulate market power and ultimately limit competition. Some public policies have contributed directly to that accumulation, such as intellectual property rights laws that favor the rights of pharmaceutical companies to profit from a drug over the rights of other companies to make it and sick people to obtain it at a reasonable cost. International trade agreements that failed to include proper safeguards made it too easy for corporations to locate their operations wherever worker bargaining rights and environmental laws were weakest.

The rapidly growing financial sector was allowed to shift “away from its essential function of allocating capital to productive uses and. . .toward predatory rent-seeking activities.” Never had so many people become so rich by producing so little of real value. Market power became enormously concentrated, with the share of assets held by the top five banks increasing from 17% to 52%. The complexity of modern finance puts ordinary consumers at a disadvantage to begin with, but the lax regulatory environment made it worse, allowing predatory lending, fraud and discrimination to run rampant. Meanwhile, the financial industry became less efficient at performing its basic function of providing credit, since the cost-per-dollar of credit actually went up.

Within corporations, the “Shareholder Revolution” increased the pressure on CEOs to generate quick profits. CEO compensation was increasingly tied to rising company stock prices. “The idea that corporations exist solely to maximize current shareholder value and that all other goals are secondary reversed decades of management theory that prioritized firm longevity and saw corporations as more broadly advancing societal interests.” This encouraged several unfortunate corporate practices: favoring shareholder payouts over long-term investments, taking excessive risks (since executives with stock options could profit from financial bubbles), paying executives much more than their productivity could justify, and treating employees “as short-term liabilities rather than as long-term assets.” The bottom line: “Corporate profits are at record highs, with no increase in investment.” Here, corporate culture is as much to blame as public policy, a reminder that the relevant rules of the game include private social norms, not just public policies and laws.

The Reagan and Bush tax cuts favored the wealthy by reducing both the upper-bracket income tax rates and the taxes on dividends and capital gains. This contributed not only to greater after-tax inequality, but surprisingly, to greater pre-tax inequality as well. It increased the pressure on companies to pay out more in executive compensation and dividends, since the payments would be more lightly taxed. International comparisons show that such tax cuts increased economic inequality but failed to boost per capita income. US Federal Reserve policy also contributed to inequality by prioritizing fighting inflation over reducing unemployment, although both goals are mandated by law. The impact of unemployment on family income varies by social class, reducing income by a higher percentage at the lower end of the income scale. In addition, “episodes of below-full employment do lasting damage to productivity, equity, and opportunity.”

During this period, US employers were generally successful in resisting any expansion of worker rights. Within the 30 democracies in the OECD, “an average of 54 percent of the workforce is covered by union collective bargaining agreements, 4.5 times more than in the US.” Companies increasingly used outsourcing and franchising to circumvent labor laws, while continuing to set the terms of employment. Wage growth fell far behind productivity growth (19% vs. 161% between 1973 and 2013), and the federal minimum wage failed to keep up with inflation. To make matters worse, one study found that about a quarter of low-wage workers were getting paid less than the minimum wage, and three quarters weren’t receiving the overtime pay they were due. One major goal of public policy was to reduce dependency on government by creating jobs and cutting social welfare payments. Instead, spending on programs like Medicaid and food stamps remained high as more working families found themselves unable to make it on their own. Conservatives deplore this, but generally oppose efforts to raise wages or strengthen the bargaining position of workers.

The final post will cover the book’s recommendations for rewriting the rules.



Capital in the Twenty-First Century (part 4)

May 23, 2014

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The twenty-first century state

The final part of Piketty’s book deals with the role of the state in 21st-century capitalist society. He focuses on two main objectives:

  • modernizing–but not dismantling–the modern “social state”
  • controlling the trend toward economic inequality by increasing the taxation of capital

The social state

The relatively strong economic growth and greater social equality of the 20th century was accompanied by–and promoted by–a larger government with greater power to tax and spend. Taxes consumed a much larger share of national income: 31% in the US, 40% in Britain, 46% in France and 54% in Sweden at their peak around 1980. (The share had been less than 10% in those same countries in the 19th century.) Public support for such high rates was easier to come by when economies were growing rapidly. High taxes enabled the state to take on new social functions. Governments invested more in the health and education of their citizens, and they provided more income security through retirement systems and support for the disabled, unemployed or otherwise economically needy.

Piketty does not expect to see a further expansion of the social state, since “the state’s great leap forward has already taken place.” He also acknowledges the need to re-examine what we already have: “The tax and transfer systems that are the heart of the modern social state are in constant need of reform and modernization, because they have achieved a level of complexity that makes them difficult to understand and threatens to undermine their social and economic efficacy.”

Piketty notes that modern taxation is no longer very progressive when all types of taxes are taken into account. He believes that how government taxes the largest incomes and fortunes is important for either reinforcing or reducing economic inequality. In the United States, tax rates on the top bracket of income averaged 81% between 1932 and 1980. Today, the top rate is 39.6% for income over $400,000 ($450,000 if married, filing jointly). As noted earlier, the recent reduction in top rates gave executives more incentive to fight for pay increases, since they could now keep most of them. Piketty does not advocate a return to the “confiscatory” rates of the past, but he would like to see a rate of at least 50% for all income over $200,000, “in order for the government to obtain the revenues it sorely needs to develop the meager US social state and invest more in health and education (while reducing the federal deficit)….”

In the US, the maximum rate for capital gains is only 20%, so the effective tax rate on total income is often lower for rich taxpayers than middle-income taxpayers. Countries have been competing against each other in a race to the bottom, trying to attract capital by taxing it lightly. Piketty hopes that more European cooperation can eventually reverse that trend. As for the United States, he ends his discussion of taxes on a pessimistic note:

The history of the progressive tax over the course of the twentieth century suggests that the risk of a drift toward oligarchy is real and gives little reason for optimism about where the United States is headed….Without a radical shock, it seems fairly likely that the current equilibrium will persist for quite some time. The egalitarian pioneer ideal has faded into oblivion, and the New World may be on the verge of becoming the Old Europe of the twenty-first century’s globalized economy.

By “Old Europe,” he means, of course, the land of inherited wealth and extreme inequality.

A global tax on capital

What is most needed to curb excessive inequality and make taxation fairer is “a progressive annual tax on individual wealth–that is, on the net value of assets each person controls.” Since it is a tax on accumulated wealth, not just current income, it would need to be set rather low, just “a few percent.” Like a property tax, it would be small, but much fairer because it would include the financial assets that make up the bulk of large fortunes. Ideally it would be imposed all over the world, but since that is unlikely to happen, the next best thing is to impose it in large areas such as the United States and a more united Europe. Otherwise capital can too easily move around to avoid it. Several European countries have taxes on capital, but they have too many loopholes to be effective.

The main justification would be “contributive”. Net assets is a fairer measure of a wealthy person’s capacity to support government than current income, which doesn’t count unrealized capital gains. A secondary justification would be giving the owners of capital more incentive to seek the best possible return. Those who earned too low a return would have to sell assets to pay their taxes, “thus ensuring that those assets wind up in the hands of more dynamic investors.”

Private wealth, public debt

Piketty finds it shameful that the richest countries in the world have such poor, indebted governments. Virtually all the capital in these countries is private capital, since whatever assets governments hold are offset by their liabilities. Financing the operations of government by borrowing rather than taxing works fine for wealthy people who would rather buy government bonds than pay taxes, but it is less efficient and less just.

Piketty’s preferred method for reducing government debt is higher taxation of capital. A second method is inflation of the money supply, which shrinks the value of the debt while spreading the cost widely through society. Inflation was the main way of reducing public debt in the 20th century, but it has to be used sparingly or it can spiral out of control. The worst method of reducing debt is austerity, which hits the poor the hardest, inhibits economic growth and increases the advantage of capital over labor, in accordance with the book’s main argument. Piketty says that “if the choice is between a little more inflation and a little more austerity, inflation is no doubt preferable.”

Economic conservatives would vigorously disagree. They place the highest priority on fighting inflation and opposing tax increases, so that austerity becomes the preferred method, at least by default. Milton Friedman and the monetarist economists saw regulation of the money supply as the central economic function of government and social spending as dangerously inflationary. “The work of Friedman and other Chicago School economists fostered suspicion of the ever-expanding state and created the intellectual climate in which the conservative revolution of 1979-1980 became possible.”

The European Union developed as a “currency without a state and a central bank without a government” at a time when inflation-fighting was coming to the forefront of public policy. The European Central Bank’s focus on controlling inflation works well for a creditor country like Germany, which can count on low inflation to preserve the value of their loans. It narrows the options of debtor countries like Greece, especially at a time when financial crisis has reduced their tax revenues and undermined confidence in their bonds. They cannot borrow at low interest rates. They cannot devalue the euro to reduce the value of their debts. They cannot effectively tax capital, or capital will just leave the country. So they are forced to prolong recession with unpopular austerity measures.

Piketty wants to see a European Union that is more of a real government, with a fiscal policy as well as an inflation-fighting monetary policy, giving it the capacity to share the debt burden and raise taxes on capital to alleviate that burden.

While the trend of the last few decades has been to deregulate capital and defund the social state, Piketty advocates a different approach for the 21st century: “Although the risk is real, I do not see any genuine alternative: If we are to regain control of capitalism, we must bet everything on democracy–and in Europe, democracy on a European scale.”

Sound Investing 8: Taxes

June 24, 2013

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Avoid unnecessary taxes

Federal tax law provides many tax breaks for investors. Among the most important are tax-sheltered retirement plans giving favorable tax treatment to money that is set aside for later years. Participants may fund the plans through payroll deductions, as in 401(k) and 403(b) plans, or through personal contributions, as in IRAs. In most plans, the contributions and the investment returns they earn are exempt from taxation until they are withdrawn in retirement. There are also tax shelters for college saving: 529 College Savings Plans and Educational Savings Accounts.

The tax shelters discussed here are perfectly legal strategies allowed by tax law in order to encourage saving. They shouldn’t be confused with tax shelters of questionable legality, such as transactions designed to create an appearance of capital losses where no real losses have occurred.

Advantages of tax-sheltered investing

To appreciate the value of tax-sheltered investment, think of it as an interest-free loan from the IRS. You get to hold onto some capital that you would have paid in taxes, make money by investing it, and keep most of the investment earnings. Better still, many employers will match a portion of the employee’s contribution to a tax-sheltered plan, which results in an instant high return on the investment.

Tax-sheltered retirement plans usually offer a number of investment options, although some plans are far more flexible than others. Changing asset allocations is usually easy because one investment can be exchanged for another with no tax consequences. A final advantage is that lower-income taxpayers can get a credit on their taxes for a portion of their annual contribution. That means that they not only exclude their contribution from their taxable income, but they reduce the amount of tax paid on the rest of their income. Most investors should consider it a high priority to contribute to tax-sheltered plans.

The Roth IRA is also a tax shelter, but it works differently from a traditional IRA or any retirement plan that is funded with pre-tax dollars. In the traditional IRA, you don’t have to pay taxes on the money you put into the account, but you do have to pay taxes on everything you take out. The Roth IRA works in reverse: You do have to pay taxes on the earnings you put in, but you don’t have to pay taxes on what you take out. When the applicable tax rate is held constant, the results are mathematically equivalent. With $4,000 to contribute and a tax rate of 25%, investing 3,000 post-tax dollars to a Roth would generate the same income as investing 4,000 pre-tax dollars to a traditional IRA and later paying taxes on the entire compounded account. In reality, the applicable tax rate may not be constant, and then the cost of present taxes must be weighed against the potential cost of future taxes. The Roth IRA can be a good deal for young workers in very low tax brackets, who by paying a little in taxes now can create a growing account that will escape taxation when they have moved to a higher bracket. For workers already in higher brackets, on the other hand, the deductibility of a traditional IRA contribution is a significant advantage. Since the deduction comes “off the top” of their income, they save taxes now at the highest rate they pay. On the other hand, if someday their IRA withdrawals constitute a large part of their income, only the portion of their withdrawals exceeding a certain bracket threshold may be taxed at the highest rate they pay. That subtle distinction may tilt the decision in favor of the traditional IRA for middle- to higher-income workers, assuming that the IRA is fully deductible (see below).

A 529 College Savings Plan works like a Roth IRA. The contributions to the plan are not tax-deductible, but the withdrawals are tax-free if used to fund higher education.

The advantages of any tax-sheltered plan are partly offset by the fees you pay for participating in it. Some of these may be unavoidable, such as the management fee charged to all participants in a 401(k) plan. Others may be minimized by careful selection of mutual funds within the plan. You can set up an IRA very inexpensively by going directly to a mutual fund company that offers no-load mutual funds or ETFs with low expenses.

Less advantageous shelters

Not all tax shelters are appropriate for all investors. Some tax shelters do shelter earnings on investment returns until withdrawal, but offer neither tax-deductible contributions (the advantage of most retirement plans), nor tax-free withdrawals (the advantage of a Roth IRA). An example is the deferred variable annuity offered by insurance companies. If you invest in it outside of an employer-sponsored retirement plan, you have to fund it with after-tax dollars. You don’t get to exclude your contributions from your taxable income, as you would in a 401(k) or traditional IRA; you only get to shelter the earnings on those contributions. And as with other shelters, when you take money out, you will have to pay taxes on the earnings at ordinary income tax rates, not the lower dividends or capital gains rates. In addition, many annuities have very high costs (see expenses).

For workers who have retirement plans through their employer, the deductibility of traditional IRA contributions phases out at higher incomes, reducing the advantage of traditional IRAs for higher-income taxpayers. (This doesn’t apply to Roth IRAs, where the contributions aren’t deductible to begin with.) You can mix deductible and non-deductible contributions within the same IRA, but the calculation of tax liability when withdrawals begin will be more complicated.

Minimizing taxes in taxable accounts

Most of the returns from bond investments take the form of interest, while most of the returns from stock investments take the form of dividends and capital gains. Interest is taxed as “ordinary income” so the rate depends on the taxpayer’s income tax bracket. Dividends and long-term capital gains (long-term refers to investments held for at least one year) are taxed at special low rates: currently 0% for taxpayers in the 10% or 15% brackets, 15% for those in the 25% to 35% brackets, and 20% for those in the top 39.6% bracket. Note, however, that all withdrawals from traditional tax shelters are taxed as ordinary income, even if the money came from dividends and capital gains; and withdrawals from Roth IRAs aren’t taxed at all. So the favored tax treatment of dividends and capital gains only applies to investments outside of tax shelters.

That means that investors in stock have another way of minimizing taxes besides deferring them in tax-shelters; they can generate tax-favored income in taxable investment accounts. That’s why wealthy investors can pay taxes at a lower rate than workers with modest incomes. But anyone fortunate enough to have non-sheltered as well as tax-sheltered investments can benefit to some degree.

In addition to being taxed at favorable rates, dividends and capital gains are easy to avoid or postpone. If you don’t need any income from your stock right now, you can avoid dividend taxes by investing in companies that retain their earnings rather than paying them out in dividends (or in mutual funds whose stated objective is growth rather than income). Your return will then be in the form of capital gains when you sell. In addition, you can put off capital gains taxes for a long time by buying and holding stocks rather than selling them frequently. People who trade frequently have to pay taxes immediately on any capital gains they realize. Frequent trading is also a problem for many mutual funds, especially actively managed funds that are trying to beat the market. They can generate a lot of capital gains that you have to pay taxes on, even if you don’t need the income. Index funds are more tax-efficient because they have lower turnover. They don’t generate very much taxable income until you decide to sell your shares. Some other mutual funds are deliberately “tax-managed” funds that try to avoid generating any taxable income, by avoiding both turnover and dividend-paying stocks. Ideally you don’t pay any taxes at all until you sell.

As we consider the principles of sound investing, we accumulate a long list of advantages of investing in index funds: They provide automatic diversification because they buy every stock in the index, low risk because they always give you close to a market return, low fees and expenses because they don’t have to do much research or trading, and high tax efficiency because of low turnover.

Prioritizing investment options

With so many kinds of tax breaks to choose from, how should investors distribute their investment dollars, especially when saving for retirement? For most employees, the first priority should be to contribute enough to their employer-sponsored retirement plan to take advantage of any matching funds contributed by the employer. If you are currently in a low tax bracket, the next priority would be to contribute the maximum allowed to a Roth IRA. Then make additional contributions to retirements plans as permitted by contribution limits, or to an educational savings plan. If you are fortunate enough to have more money to invest than you are willing and able to shelter from taxes, put it into investments that either generate little taxable income or that take advantage of the low tax rates on dividends and capital gains.

As you prioritize for tax purposes, don’t become so impressed by the tax advantages of stock investing that you lose sight of the benefits of a balanced asset allocation.

Dividing investments between taxable and sheltered accounts

If you have both tax-sheltered investments and taxable investments, which investments to put in which category can be tricky. This is sometimes called the asset location question as opposed to the asset allocation question. One consideration is time horizon. If your taxable investments are short-term investments, then they should be conservatively invested in cash and bonds rather than stock. In that case, hold your stock in your tax-sheltered retirement account, where it has time to ride out the ups and downs of the market.

But if you also have long-term taxable investments, you have more options. Now you need to decide which of your long-term investments belong in your tax shelter, and which belong in your taxable account. The investments that benefit the most from tax sheltering are those with both a high return and a potential to generate current taxable income. Real estate investment trusts, high-dividend stocks, and actively managed mutual funds realizing a lot of capital gains would be in this category. Investments that benefit the least from tax sheltering are stocks that are held for appreciation rather than dividends, or tax-efficient index funds that rarely realize capital gains by selling shares. They generate little taxable income now, and when you realize your gains in retirement they will be taxed at low capital gains rates. But if they are held in a traditional tax shelter (not a Roth), the gains will eventually be taxed at ordinary income rates when you make withdrawals. You get a tax break when you put money in, but forfeit a tax break when you take money out.

That doesn’t mean that index funds never belong in tax shelters. It makes sense to set up a retirement plan where you can invest with pre-tax dollars, and it also makes sense to own index funds for their diversification, low risk and low expenses. If your retirement plan is all you have in long-term savings, then that’s where your index funds will be. But if you have a choice, keep your most tax-efficient investments in your taxable account and less tax-efficient investments in your tax shelter. This distinction is most important for investments with a high long-term return, such as stock, real estate and commodities. The stakes are not as high for bonds, although bonds with higher yields do benefit from tax sheltering more than bonds with lower yields. Treasury bonds benefit a little less from sheltering than corporate bonds, since treasuries are already exempt from state taxes. Municipal bonds are not appropriate for tax shelters at all, since they are exempt from federal taxes.

The Roth IRA is a special situation because you’ve already paid your taxes before you put the money in, and the earnings will never be taxed at any rate. So you may want to invest a Roth in whatever you expect to give you the highest long-run total return, consistent with your tolerance for risk. That could be something like a small-cap value stock fund.