The presidential election has seen a variety of tax proposals floated by the candidates. One of the most aggressive, proposed by Bernie Sanders, would take away the tax advantage given to investments. Specifically, he proposed that dividends and long-term gains be taxed the same as ordinary income. 

If such a proposal ultimately passed, it wouldn't be the first time there would be no differential in tax rates between ordinary and investment income. As a matter of fact, up until the 1970s, investment income was taxed at a higher rate than ordinary income, the opposite of more recent times.

With more tax changes likely, as history shows, it's important that advisors point out to their clients the different possibilities to consider when deciding to defer taxes on investments. 

Clients may believe it’s always better to defer. The theory behind this tenet is that money should be allowed to grow before any tax bite is inflicted. But no one knows what the tax rate will be when the time comes to take the money out. Research suggests the benefits of tax deferral depend on the interaction of investment returns, deferral time frames and, most important, changes in tax rates. That explains why deferral is sometimes not a very good idea. 


Clients who analyze the benefits of deferral often times assume their tax rate will remain the same. But over the past 90 years, tax rates have actually been quite volatile. 

When income tax was introduced in 1913, the top rate was only 7%. Within a decade, it rose to 77%, then fell to 25%. At the end of World War II, the top marginal rate was 94%. In this context, the current top rate of 39.6% seems relatively low.

The danger for clients and other investors is clear. If you choose to defer taxes now and rates move to 90%, you’ve exchanged a tax of 39.6% for one of 90%. Such a drastic rate spike seems highly unlikely in the near future, but any tax increase can shrink or even outweigh the benefit of deferral.  

In this context, two other factors become important: time frames and investment returns. The longer your client's time frame, the greater the value of compounding through deferral. If your client is investing for their grandchild’s retirement 65 or 70 years from now, then deferral is almost certainly their best strategy: Even if rates do rise to 90% by then, deferral would be better than paying tax now at 39.6%, as long as annual returns are over 7%. 

On the other hand, if your client needs money for their own retirement in 20 years and tax rates at that time reach 90%, their returns would need to have compounded at 45% a year in order for deferral to have made sense. And these calculations assume no added cost/fees or frictions to create the deferral. 

The chart below shows the tax rates and approximate investment returns required for deferral to be profitable for investments with a 10-year time frame. It assumes that tax rates remain at 39.6% until the tenth year. You can see that a 10% return is outstripped if tax rates are above 50%; a 5% return can only support a tax rate of 45% or less at the end of the 10 years.  

This research builds on earlier academic studies by James Poterba of MIT. In “Saving For Retirement: Taxes Matter,” Poterba found that, if an investor’s tax bracket remains the same or falls upon retirement, then that investor would benefit by having retirement savings in tax-deferred vehicles.  However, if the investor moves to a higher tax bracket upon retirement, then in some situations, immediate taxation would have been a better choice for that investor. 

Robert Gordon is a contributing writer for On Wall Street, adjunct professor at New York University Stern School of Business and president of Twenty-First Securities.

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