Why U.S. tax policy makes saving a sucker's game.

How to understand Wall Street.
April 12 2007 1:06 PM

Spend Every Dime!

Why U.S. tax policy makes saving a sucker's game.

Illustration by Alex Eben Meyer. Click image to expand.

For the first time since the Great Depression, the U.S. personal savings rate has "gone negative." In 2005 and 2006, U.S. citizens spent more than they made. Economists disagree about just how ominous this is, but they generally agree on why it's happening. Americans are "overspending."

Why are we doing this? Partly because we're acquisitive consumers obsessed with instant gratification and toys. Partly because soaring real-estate and stock markets make us feel rich. But also partly because we're not suckers. Perverse tax laws for investments discourage saving, so it's no surprise we spend.


If I said to you, "You can have $10,000 to spend now—or $9,500 to spend in 10 years," which would you choose? Probably the $10,000 now. And in doing so, you would be making the same choice many Americans make when deciding whether to save or spend their hard-earned cash.

The problem is how we tax investment gains. Over the past 80 years, the average annual return on Treasury bills (a proxy for savings accounts) has been 3.7 percent per year. Inflation, meanwhile, has averaged 3.1 percent per year. This combination has produced a "real return" of a paltry 0.6 percent per year. If you got to keep that 0.6 percent, you might still have an incentive to save: A $616 real gain on $10,000 in 10 years wouldn't be much, but it would at least be $616 more than you have now. Unless you're so poor that you're exempt from taxes, however, or so flush that you can afford to lock up cash for decades in a tax-deferred annuity or retirement account, you won't be keeping that 0.6 percent. You'll be giving all of it—and probably more—to the government.

How does the math work? Let's say your T-bills return 3.7 percent. If you stash $10,000, you'll make $370 before taxes and inflation in the first year. Taxes are assessed on the nominal gain (before adjusting for inflation) instead of the real gain, so if you're in the 15 percent tax bracket, you'll then pay $56 to the government—and lose about $310 of value to inflation. In other words, you'll eke out about a $5 real gain on a $10,000 investment (an 0.05 percent return). If you're in higher brackets, meanwhile, you'll actually lose about 0.5 percent of value every year. The only time you'll generate real gains is when "real" rates of return are significantly higher than 0.6 percent (as they are now). But when real rates are negative, as they were a few years ago, you'll be losing a lot more than 0.5 percent per year.

Fine, you say. T-bills are for chumps. Stocks provide a far better long-term return, and—if you don't trade like Jim Cramer—they're more tax efficient: Hold your stocks for more than a year, and you'll pay only long-term capital gains tax, not income tax. And you'll get sweetheart rates on dividends, too.

If your time horizon is long enough, this is true. Unlike T-bills or bank accounts, stocks compound tax free, so you won't owe tax until you sell them (except, again, on the dividends). Yet even stocks aren't ideal for savings. For one thing, there are those annoying bear markets: The S&P 500 is still below where it was seven years ago, even before adjusting for inflation. Then there are dividend taxes: In the 20th century, nearly half of the average 10 percent annual return on U.S. stocks came from dividends, not price appreciation, and you pay taxes on dividends every year. Lastly, there's the absurd way that the IRS accounts for "realized gains." Once you're in the black on a stock or fund, current tax policy forces you to stick with it—or get socked with a capital-gains tax bill. In other words, even if your stock's best gains are behind it, if you switch to a better stock, it might be years after paying your tax bill before you get back to even.

Can you reduce savings taxes? Yes, if you're skilled and well-informed, you can "harvest losses," buy "tax-managed" funds, and implement other tax-minimization strategies. Doing so will usually consume money and time, however, and be a major headache. And you'll still have the bear-market problem: Unless you're in your 20s or 30s and saving for retirement, stocks are too risky to represent your entire portfolio. So, given current tax policy, it's no wonder we're not saving anything.

How could we fix this?

For starters, we could do the same thing for regular savers as we do for real-estate investors: Change the definition of a "realized gain." Real-estate investors can take advantage of a "1031 Exchange," which allows them to take gains from the sale of one property and reinvest them in another without triggering a tax event. The same system should apply to other investments: If you own a stock or fund that has doubled, you shouldn't be forced to hang onto it just to avoid triggering a taxable gain. Instead, you should be able to sell it and invest the proceeds in another stock or fund. Gains should only be "realized" when you take the money out of your investment account and spend it.

Second, to avoid encouraging too much risk-taking, we should treat interest earned in long-term savings accounts as capital gains, not income. This would remove the tax-disadvantages associated with owning safe, income-generating assets as compared to more volatile stocks.

Third, if we really want to encourage saving, we should make long-term savings tax exempt. Even today's retirement vehicles are only tax-deferred: Your money compounds tax-free, but then you have to fork over income tax on withdrawals (neutralizing much of the advantage). Tax-exempt savings accounts don't sound so radical, but when the Bush administration proposed them back in 2003, the insurance industry went nuts: Such accounts might reduce demand for expensive tax-deferred annuities! There were also protests that such accounts would disproportionately benefit those who could afford to save—an issue that could easily be addressed through limited per-year contributions or regular tax rates above a certain level of earnings. In any case, the "Lifetime Savings Accounts" idea now seems to be dead.

So, what our current tax code is saying is, "Don't be a sucker: Spend every dime." And as the personal-savings figures show, that's just what we're doing.



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