Investors contemplating an Individual Retirement Account (IRA) want to be assured that if they have to withdraw funds before age 59½, incurring the 10 per cent penalty tax, they will not be worse off than if they had made an equivalent investment outside the IRA. The break-even holding period—the years until the investor can withdraw IRA funds, pay both the regular income tax and penalty tax, and have an after-tax amount equal to the after-tax accumulation outside the IRA—depends on three factors.
The higher the rate of return on the investment and the higher the investor’s marginal tax rate, the more advantageous the tax-deferred compounding offered by the IRA, hence the shorter the break-even holding period. On the other hand, the higher the proportion of capital-gains appreciation component of total return, the longer the break-even period will be. Capital gains realized outside the IRA will benefit from lower capital-gains tax rates. Failure to account for this effect may lead investors to underestimate break-even holding periods.