Does a traditional IRA actually save you capital gains tax?

Ordinary income tax is always at least as high as one’s cap gain rate.

What you observe is actually a downside of the pretax retirement account structure. In effect, it converts potential long term gains into ordinary income.

It also takes that wealth and excludes it from a potential step up on the owner’s death. i.e. no step up, just ordinary income when the kids withdraw it.

You are effectively paying tax on the gains, but the treatment and rate are different than if you had made the same investments in a non-tax-advantaged account.

Let's assume you plan to invest some amount of money (e.g. purchase X shares of ABC stock), and hold the investment until retirement.

If you forego the IRA contribution and invest in a taxable account, then you pay the full amount of income tax up front (up front as in when you pay taxes for the current year, as opposed to years down the road when you withdraw; not up front as in immediately today) on the money based on your current tax situation. You then have less money to invest (how much less depends on your exact situation, might be a tiny difference). Any dividends paid over the years are taxed at your normal income tax rate the year they are paid. When you eventually sell the shares, your initial cost basis is not taxed, and the gains are taxed at a favorable rate (possibly even 0% for long-term gains, depending on your other income in the year you sell).

If you make the IRA contribution, you save some amount on your taxes this year (assuming it is a deductible contribution). The exact amount depends on your specific tax situation. None of the dividends paid over the years are taxed (at least not at the time they are paid). When you withdraw the money from the IRA, the full amount of the withdrawal is taxed as ordinary income. Depending on your other income in the year of the withdrawal, this could be a small tax (even 0 if your total income is below the standard deduction).

So yes, technically, you will still be liable for taxes on the gains, although it won't be called "capital gains tax" and won't get the (currently) more favorable tax rate. However, there is a bit of predictive guesswork that goes into determining whether that is more favorable or less. You can plan (to a certain extent) what you expect your income to be (will you continue working full-time after age 59? work part time? no work at all?), but it is not safe to assume that tax rates, brackets, or even general rules (e.g. gains vs ordinary income taxed different, long vs. short distinction, etc.) will be the same in the future.

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There are two other things to consider here:

• If you decide you no longer like being invested in ABC, and instead want to invest in XYZ, then you need to sell your shares of ABC and buy XYZ. Within your IRA, there will be no tax at all on this transaction (and any loss will not be tax-deductible). In a taxable account, you will be liable for taxes on any gains on the sale (or can deduct any loss).

• If you expect to need the money while you are younger, the IRA is a worse option because in addition to the entire withdrawal being taxed as ordinary income (adding to your other income for the year, assuming you are still working), you will pay a penalty; with a taxable account, only the gains are taxed, they're (currently) taxed at a lower rate, and there is no penalty (or you can deduct a loss if you sell at a bad time).

The key point is that the immediate tax deduction for traditional IRA contributions means that you can contribute more than you could otherwise, for the same out-of-pocket cost. For example, if you have $3k/year slack in your budget for savings, and your marginal tax rate is 25%, you can either save $3k/year in a taxable account (or Roth IRA), or save $4k/year in a traditional IRA (because doing so will put $1k/year back in your pocket in tax savings). Thus, you should compare the balance in a traditional IRA to an alternative savings balance that would be 25% smaller.

Years later, in retirement, let's say your traditional IRA balance is $400k. As you make withdrawals, let's say you continue to pay 25% tax. Then, it is the same as if you had a $300k balance and withdrawals were tax-free. Indeed, $300k is what your balance would be in a Roth IRA, so in this sense traditional and Roth are equivalent. In a taxable account, your balance would be $300k minus the effect of any tax you paid along the way on interest and dividends, and your withdrawals would involve tax on gains, so you'd do worse than either type of IRA.

Gains on an IRA are effectively tax free.

Consider a simple example. Suppose you put $1000 into a traditional IRA, By the time you withdraw it, the value of the account has doubled. You are in a 15% marginal tax bracket. For the purposes of this example, assume you are in the same tax bracket when you put the money in as when you take it out.

Scenario 1: You deposit $1000 to your IRA. It's tax deferred so you pay no tax at the time you deposit. When you withdraw the money it has doubled to $2000. You now pay 15%, or $300, leaving you $1700.

Scenario 2: Instead of depositing the money in an IRA, suppose there was some alternative account you could deposit money to where you pay taxes normally when you earn the money, but you pay no taxes on capital gains. I'm not saying there's any such tax law, just creating a hypothetical for comparison. So when you earn the $1000, you have to pay $150 in taxes, leaving $850. By the time you withdraw, it has doubled to $1700. You pay no taxes on the capital gain, so you are left with $1700. Note this is the same amount you had in scenario 1.

Instead of using sample numbers you could do a little algebra and you'd see that this is true regardless of the amount and the tax rate. So one way of looking at an IRA is to say that the net effect is that capital gains are tax free.

(Let P be the initial principle, r be the growth factor over the life of the investment, and t be the tax rate. Then in scenario 1, the amount of money you have at the end is P(100%-t)r. In scenario 2 it's Pr(100%-t). As multiplication is associative, these two will expressions are equal.)

Oh, and note that my scenario 2 is basically how a Roth IRA works, so there really is such an account. They just don't describe it that way.

BTW, a crucial assumption in this example is that your tax rate when you put the money in is the same as your tax rate when you take it out. For most people, that assumption is NOT valid. Most of us are in a higher tax bracket when we're working than when we retire. So by deferring taxes until you retire, even if you did pay taxes on the increase, you'd still be better off because you'd be paying taxes at a lower rate.