The tax simplicity of tax deferred accounts

A common question is whether to put money in a 401K or IRA or not. Unfortunately, there are a daunting number of options and an even more bewildering battery of rules for each choice.

However, one often ignored but compelling reason to put money in a tax deferred account (401k, 403b, IRA) is simplicity. Tax simplicity in particular.

If you're just starting to invest or your accounts are relatively simple, then this may seem like a moot point.
But as time goes on and your portfolio grows and becomes more diverse, you will soon find that filing your taxes and keeping all the bookwork starts to take a life of its own. A time consuming, minutae filled life.
And typically it only gets worse over time.

Assume you are a long term investor and buy a mutual fund and just hold it for 7 years. And you reinvest all dividends and capital gains. What can be so bad? It's the regular dividend and capital gains distributions.

Let's take the Vanguard S&P 500 Index VFINX, a widely held mutual fund (the third largest as of Mar 2007). It is a well-behaved fund as it has few if any capital gains distributrions, from selling appreciated stock, in part because it is a growing fund (so all they do is buy more) and in part because it is very well run. But it does have quarterly dividend payouts. (As an aside, the Vanguard website on VFINX indicates the unrealized capital gain in the fund price is very significant at 38% of the NAV, meaning they are holding lots of appreciated stock).

Let's outline the problem(s) of the dividend payout.
- On every dividend payout, you have to add them all up and pay taxes at the end of the year. No big deal.
- Each time you reinvested dividends, you buy a bit more of the fund, at the price on the dividend payout. Not a big the first time, but it starts to get worse.

After 5 years, you have made 21 different purchases, 20 of which were dividend reinvestments for small amounts at different prices and different amounts. You essentially have 21 positions in VFINX. Yow.

Eventually, if you sell all of your holdings, at tax time it is a tedious calculation mess, because you are essentially selling out of 21 different positions, all of VFINX. But at least you are done with that investment once and for all, from a tax standpoint.

But if you only sell a fraction of your holdings, say to rebalance, then you have a mess now and bigger mess later. You have to decide from a tax standpoint which shares you sold - (a) the original shares, or (b) the most recent shares bought by divident reinvestment or (c)perhaps you sold all shares proportionally. The simplest taxwise is (a) but this is likely the worse from a tax payment standpoint as the original shares have appreciated the most. If the price has gone up somewhat steadily you might choose (b) to minimize your tax burden, but might want to sell shares you've had for at least 12 months for LT gains. Finally, I cannot recommend (c) under any circumstance as it complicates the books now and especially in the future.

Now imaging if you buy or sell more shares every year moving forward due to rebalancing concerns. As you can see the bookkeeping just keeps getting uglier. After 4 years of rebalancing, it isn't hard to imagine having 30+ positions of VFINX, many of which had already had some buying and selling. It takes several years to reach that point, but if all goes well for you, you will reach that point.

The other alternative is to not reinvest dividends or cap gains. However, this creates small bits of cash in your portfolio at regular intervals, which is hard to invest. If you want to cash for cash flow, that's OK, but it is irregular in that you can't predict cap gains very well. And if you are constantly pulling out cash, it is harder to determine return. So I assume you want to reinvest, if at all possible.

In contrast to all this, having a tax deferred account is very simple.

1. If is a Roth, you never pay taxes. This is the simplest. The Roth is my favorite vehicle, though both the Roth and the pretax 401k/IRA have roughly equal tradeoffs.
   
2. If it a pretax IRA or pretax 401k, you pay ordinary income on everything you withdraw. Again very simple from a tax stand point.
   
3. If it is a post tax IRA or 401k, it is a bit more compliated but again not too bad. And you get to defer all this work until you actually withdraw, so it is still a procrastinators dream.