A Roth IRA is exempt from income and capital gains tax.
A non-dividend paying stock, e.g., Berkshire Hathaway, is similar to a Roth if you hold the shares until death’s stepped-up basis.
Unlike the Roth, no annual limit exists on “contributions” to an investment in non-dividend paying stock.
With no dividend, you pay no income tax.
At death, your heir gets a stepped-up basis, so no capital gains tax is due if the heir immediately sells the stock.
The stock is a de facto Roth, but has some disadvantages relative to an actual Roth. The latter can hold a more diversified portfolio, with no tax consequences when shifting among different assets. In contrast, with a de facto Roth, to avoid capital gains tax on any appreciation, you must retain an asset until death.
One risk of the de facto Roth is that a company may switch to paying dividends. Also, in bankruptcy, federal law and certain state laws provide either complete or partial protection to some IRAs. Such a shield would not extend to stock held outright.
Although Berkshire Hathaway has key-person risk, the corporation has a rigid policy against dividends and is a diversified and profitable enterprise whose shares may complement an already-held “broad” U.S. stock index fund, which is capitalization-weighted and therefore heavy with technology/mega-capitalization shares.
In any event, if your holdings continue to pay no dividends and you are satisfied with retaining the assets for the rest of your life, during that time they incur no income or capital gains tax.
What if your heir continues to hold?
The non-dividend paying stock will generate no income tax. Nevertheless, at sale, capital gains tax is due on any appreciation since inheritance. Your heir may avoid a sale by either donating the shares to charity or holding until death.
In contrast, the inherited Roth remains exempt from income and capital gains tax. When a Roth IRA passes to a non-spousal beneficiary, however, the SECURE Act generally requires the beneficiary to liquidate the Roth within 10 years (with no tax).
In short, before death, non-dividend paying shares held until then are roughly equivalent tax-wise to a Roth. After death, the inherited Roth has advantages relative to inherited non-dividend paying stock, but a non-spousal Roth beneficiary must liquidate within 10 years.
What if you are uncomfortable with a portfolio owning only non-dividend paying shares? By incurring a little taxable income, you could expand to low-dividend payers.
In fact, solely by holding until death, you avoid most tax on returns. Suppose you invest $100,000 in a S&P 500 exchange-traded-fund. Assume the annual dividend yield is 1.7%, a total of $1,700. If your combined state and federal income tax rate for dividends is 25%, your yearly tax on $1,700 of dividends is $425.
Holding the S&P 500 outright until death is a quasi-de-facto Roth, with relatively little tax, but not zero.
To digress, what if you wish to invest in debt securities rather than equities? Although with a lower yield, tax-exempt municipals of your state would be roughly equivalent tax-wise to a Roth holding taxable fixed-income.
Investing In Non-Dividend Paying Stock To Reverse RMD
As discussed in my earlier piece, “Myths About the Traditional and Roth 401(k)/IRA That Affect How People Use Them,” Bloomberg BNA Daily Tax Report (Feb. 3, 2020) [hereinafter Myths], the traditional 401(k)/IRA [hereinafter “traditional”] is in effect a joint venture between you and the government. When you initially invest, the government also puts up money—the otherwise-owed income tax on the earned income. It is as if the government collects that tax and then invests it in the joint venture.
At eventual withdrawal (partial liquidation) from the traditional, the so-called “income tax” collected by the government is really its ownership share. At withdrawal, that ownership portion is based on the tax rate at the time and could be lower or higher than the government’s original percentage contribution.
The part of the venture you own is exempt from all income and capital gains tax and is in effect a “Roth” within the traditional.
A retiree who reaches a certain age generally must take required minimum distributions (RMD) from the traditional. The distribution is a partial liquidation of the joint venture, with each party taking the portion already owned.
With the RMD partial liquidation, the government’s collection of its ownership share does not harm you (unless you will later be in a lower tax bracket, when the government in effect decreases its ownership percentage).
Nevertheless, RMD does make you worse off because your ownership portion that you receive is a partial redemption of your tax-exempt ‘‘Roth’’ within the traditional.
The RMD causes you to lose part of your “Roth” within the traditional, but your investment of the after-“tax” distribution in non-dividend paying shares restores an equivalent dollar amount in de facto Roth.
In other words, from the RMD partial liquidation distribution, you give the government its ownership portion, take yours, and invest it in an amount of de facto Roth exactly equal to the value of what you withdrew from your tax-exempt “Roth” within the joint venture traditional.
As discussed previously, this de facto Roth has some drawbacks. Relative to the “Roth” within the traditional, however, the non-dividend paying stock has an advantage; it is not subject to RMD.
In any event, if you do not welcome part or all of your RMD, this method is a way largely to reverse it.
As mentioned before, even if you do not wish to own solely non-dividend paying shares, by holding until death, you create a quasi-de-facto Roth, with relatively little tax, although not zero.
To digress, if you take RMD from fixed-income holdings rather than equities, you can roughly recreate tax-wise your lost “Roth” within the traditional by investing your after-“tax” distribution in tax-exempt municipals of your state, although at a lower yield.
All this said, as discussed in my earlier mentioned Myths piece, if your tax bracket at would-be distribution will be the same or higher than at Roth conversion, the conversion is costless and has many benefits, including avoiding RMD.
William K.S. Wang is emeritus professor at the University of California College of the Law, San Francisco.