on bonds has also increased as a result of the drop in the tax rates on or-
dinary income, the increase in the real return on stocks has been greater.
In any equilibrium model of asset pricing, the favorable tax factors for
equities suggest that stocks should be priced at a higher multiple of
earnings. This will be discussed in Chapter 8.STOCKS OR BONDS IN TAX-DEFERRED ACCOUNTS?
The most important savings vehicles for many individuals are their tax-
deferred accounts (TDAs) such as Keogh, IRA, and 401(k) plans. Many
investors hold most of their stock (if they hold any at all) in their tax-de-
ferred accounts, while they hold primarily fixed-income assets in their
taxable accounts.
Yet many of the recent changes in the tax laws argue that investors
should do the opposite. Dividends will enjoy the lower tax rates and ap-
preciation on shares will gain the lower capital gains tax advantage only
if they are held in taxable accounts. This is because when a tax-deferred
account is cashed out at retirement, an individual pays the full ordinary
income tax on the entire withdrawal regardless of how much of the ac-
cumulation has been realized through capital gains and how much
through dividend income.
The above counsel, however, ignores two factors. First, if you are
an active trader or buy mutual funds that actively trade, then there may
be significant capital gains realized, some short run, that would be best
kept in a tax-deferred account. Trading in tax-deferred accounts also
does not require complicated tax computations since there are no taxes
paid until money is withdrawn and the source of the money is of no
consequence.
Second, although the government taxes your capital gains and div-
idends at ordinary rates when withdrawn from a TDA, the government
also shares more of the risk. If you realize a capital loss in a taxable ac-
count, the government limits your ability to offset this loss against ordi-
nary income. However, when funds are withdrawn from a tax-deferred
account, the full withdrawal is treated as taxable income, so that all
losses become totally deductible from taxable income. Therefore, there is
less after-tax risk putting your money in tax-deferred accounts.
When all the factors are considered, it is better for most investors to
hold stocks in their taxable accounts, unless they are active traders. If
you have a long horizon, the possibility that you will have a loss in your
stock accounts is minimal, so the loss-sharing aspect of TDAs is less
important. It is advisable, however, to hold stocks that do not pay tax-CHAPTER 5 The Impact of Taxes on Stock and Bond Returns 73