Today I had to clean off my desk. I need room to maneuver and there are piles of papers everywhere.

I came across an article from Research Magazine, November2009 edition, by Moshe A. Milevsky, PHD titled Back To Basics? Since I had ripped the article out of the magazine some time ago I thought I’d read it.

It’s too long to give you the whole article so I’ll give you my take on it. Milevsky is an academic and did a comparison of a $100 investment that he calculated out in three generic income tax structures at a rate of 7.29% return net of fees each year.

Structure #1 is No Tax Ever. Structure #2 is High-rate, tax deferred and Structure #3 ia Low-rate, continuously taxed.

In the No Tax Ever structure, the entire gain is never taxed. In 10 years, the initial $100 investment grows to approximately $202 and after 30 years it grows to $826. You can confirm this by multiplying $100 times 7.29% times the number of years. You need to use a financial calculator to do the computation.

In the high-rate, tax-deferred structure, your gains are tax-deferred while the money is invested. Once cashed in or the funds are withdrawn you pay income taxes on all the gains at your personal income tax rate. Using a 35% tax rate this leads to after-tax account values of about $166 in year 10 and $572 in year 30.

In the low-rate, continuous-tax structure, you pay capital gains taxes on all investment gains as they occur, but at a relatively low rate of 20%. When you eventually withdraw the funds, no additional income taxes are due. The value of your portfolio in year 10 is approximately $176 and $548 in year 30.

The end result of all of this is that after 35 years Structure #1 has value of 1,173.70, Structure #2 has value of $797.90 and Structure #3 of $727.10.

Comparing the after-tax results at different points in time I understand that the No Tax Ever structure always leads to the highest portfolio value. The gap between this and the other two structures widens as the holding period lengthens.

In Structure #2, the tax-deferred structure, the portfolio value is lower compared to Structure #3 for the first 25 years—the disadvantage disappears in year 25. In year 25 the after-tax value of both structures is equal.

The conclusion we both came to is that if you are investing for the short term it makes sense to use Strategy #1 or Strategy #3 and pay the capital gains tax annually. If you are investing for the long term Strategy #1 or Strategy #2 using a tax-deferred annuity makes sense. You incur the higher tax, assuming a 35% tax rate when you withdraw your gain from the annuity (Strategy #2). There’s a calculator at www.qwema.ca where you can compute the break-even point for any combination of time horizons, tax structures and tax rates.

I disagree with Milevsky when he says you have to die to avoid the ‘no tax ever’ investment plan. Putting your money into a Roth IRA gives you ‘no tax ever’. After five years in a Roth IRA you can withdraw funds tax free.

I’d like to hear your opinions and if you would like a copy of the article from Research Magazine with the Chart I can email it to you.

You can reach me by phone at 818 706-3745 or by email: Sandra@Insurance-California.com.

Sandra Cherry, PFP CA Insurance License #0B45111

SandraCherryFinancialPlanner.com