Pretty much all governments around the world encourage their citizens to invest in some kind of retirement fund (pension plans) by providing tax advantages in these investments. These tax breaks are the main benefit of retirement funds. Some countries do not tax retirement funds until the capital is withdrawn; some let you deduct the capital invested in the retirement fund from your annual taxable income (however you may will still need to pay tax on these contributions and on their financial growth at withdrawal); some tax retirement funds but at a lower rate; some make these funds completely tax free; and some mix multiple benefits. As we already saw in other articles, taxation on investments can have a huge impact on one's wealth in the long term. Therefore, any kind of tax break should be welcome, given that all other factors are equal.
The Pitfalls of Retirement Funds
1. Sub-optimal investment options. A frequent problem of retirement funds (pension plans) is that their investment options are very limited. Using retirement funds, you may not be able to invest:
- In low-cost funds or ETFs. On average, investors lose 300 thousand in 30 years for each 100 thousand invested in high-cost funds (actively managed funds).
- In total market ETFs or index funds, although small and value stocks outperform large and growth stocks in the long term and are great investments for retirement.
- Internationally, although diversifying your investments between countries can lead to higher gains and lower risks.
- Emerging markets, although even the purchase of riskier assets can decrease the risk of a portfolio as Nobel Laureate Harry Markowitz has shown.
2. Unclear taxation benefits.
- A major assumption of retirement funds is that you will always need to pay taxes on financial gains. If you can become tax-free, retirement fund investments make no sense. However, as we already saw in "Legal Tax Reduction" there are many ways to legally pay 0% tax. And even if you need to pay tax today, it is possible to hold your investments in a no-tax jurisdiction and sell these assets only when you have a fiscal residency on a no-tax or territorial jurisdiction, legally removing all tax duties on those gains. At Moraya Consulting, we can help interested clients set up these advanced taxation strategies.
- Moreover, retirement funds that only let you postpone the tax until the withdrawal date are especially problematic. Capital gain tax is not applied until the asset, like the stock, is sold. Therefore, retirement funds that only give you the advantage of being taxed at the withdrawal can be pretty much useless since you could enjoy this benefit without the retirement fund. It is true that some investments cannot be held indefinitely. Bond gains, for example, must be received at the maturity date and taxed at that point. However, the bulk of your long term investments should be in stocks anyway. Stocks not only far outperform other asset classes in the long term but become less risky with time. In fact, for 15-20+ year investment stocks are less risky than bonds.
- Some governments tax retirement funds like normal income rather than capital gains. But capital gains tax is often lower than normal income tax (Sorensen, 2010). Therefore, postponing your withdraw in a retirement fund can potentially increase your tax duties.
- Even if the government taxes retirement funds with standard capital gain tax at the withdrawal date, it is very possible that the capital gain tax will be higher in the future than it is today. Currently, there are strong political groups in favor of increasing capital gain tax as they (incorrectly) claim it to be a way to decrease wealth inequality. Moreover, in the last 200 years, the overall trend of governments around the world has been to increase taxation on its citizens (Steinmo, 1993).
- If your government lets you deduct the capital invested in the retirement fund from your annual taxable income but requires you to pay capital gains in these investments at withdrawal, specific calculations must be made to see if allocating resources in retirement funds is worthy. The benefit is that you decrease your tax duties today but you will possibly have to bear the usually higher normal income taxation on your investment gains that could have been taxed using the lower capital gains tax outside of the retirement fund or not tax at all. Not to mention the sub-optimal investment options and illiquidity problems of retirement fund that you need to accept.
- Almost always, you can only withdraw capital from retirement funds at a very old age, i.e. very low liquidity. What if you have a financial emergency? What if you die before that age? Of course, there are regulations for emergency health situations but those are sometimes difficult to prove, especially if you are abroad when that happens.
- The very low liquidity of retirement funds is also a great opportunity for governments and private institutions with financial problems. During the 2008 crisis, for example, retirement funds of many citizens in the European Union country of Cyprus were stolen from their owners to alleviate financial mismanagements of others (Casey and Panayiotis, 2013). Although most people do not think about the possibility of default, it must be taken into consideration.
Thus, at Moraya Consulting, we do not say to never invest in retirement funds because their tax benefits can still be advantageous for some investors. However, there are severe limitations on retirement fund investing and any capital allocated in this asset type must be very well planned and analyzed. If investing in retirement funds (pension plans) makes sense for you, behavioral economics has indicated that the best way to do so is to join an automatic enrollment and automatic savings plan (Thaler and Sunstein, 2008). This happens because individuals have a status quo bias (Samuelson and Zeckhauser, 1988), i.e. you are much more likely to continue investing if the capital is automatically removed from your account or salary compared to having to manually invest every month.
- Casey, Bernard. and Yiallouros, Panayiotis (2013). The Slow Growth and Sudden Demise of Supplementary Pension Provision in Cyprus . Cyprus Economic Policy Review, 7(2), pp. 25-51.
- Steinmo, Sven (1993). Taxation and Democracy: Swedish, British and American Approaches to Financing the Modern State. Yale University Press.
- Samuelson, William, and Richard J. Zeckhauser (1988). “Status Quo Bias in Decision Making.” Journal of Risk and Uncertainty 1: 7–59.
- Sorensen, Peter (2010). “Dual Income Taxes a Nordic Tax System.” In Tax Reform in Open Economies, ed. Iris Claus, Normal Gemmell, Michelle Harding, and David White. London: Edward Elgar.
- Thaler, Richard H., and Sunstein, Cass R. (2008). Nudge: Improving Decisions About Health, Wealth, And Happiness. New Haven: Yale University Press.
IMPORTANT: THERE IS NO ONE BEST TAX OR INVESTMENT STRATEGY. IT ALL DEPENDS ON YOUR GOALS, RESOURCES, AND CITIZENSHIP.
For example, are you willing to move abroad? If so, where? How long do want to stay in each place? What is your annual income? How much money are you willing to invest? Do you want short term gains or long-term investments? What is (are) the source(s) of your income? How much taxes do you pay annually? Do you want to decrease your tax duties or completely remove them? Do you feel like you want to pay some taxes even if you do not need to? What is your citizenship? Do you have multiple citizenships? Depending on each of these answers the best investment/tax strategy for you will differ. To see what option is best for you and to help with the implementation of the strategy feel free to reach out to us. You do not need to be rich to create a global investment portfolio. Most of the bank and brokerage accounts we open do not have minimum initial deposit or maintenance fees. Thus, you can invest as much as you want or even leave the accounts empty until you have enough capital or interest to invest abroad.