Gold has lured investors for centuries for its rarity and beauty, which explains why nearly half of gold demand worldwide is by the jewelry industry (World Gold Council, Gold Investor, Vol. 7, September 2014, page 8). Another 32% of gold demand is for gold bars and coins—gold bullion. An investment in gold bullion in 2004 would have provided a pretax annualized return of over 12% over the ensuing 10 years.
This return is not without its risks, however. Over the past several years, gold prices have dropped dramatically, and a 2012 investment in gold would have returned an annualized pretax loss of over 14%. The volatility of commodities including gold, however, is only part of the story.
For tax purposes, physical gold investments are classified as collectibles. Gains on collectibles held for one year or less are taxed as ordinary income—the same tax treatment as short-term capital gains (STCGs). Gains on collectibles held more than one year are taxed as ordinary income, except the maximum collectibles tax rate is 28% (Sec. 1(h)(4)). The 28% maximum collectibles tax rate is sharply higher than the 15% long-term capital gain (LTCG) rate that applies to most other assets and taxpayers (with a 20% maximum LTCG rate applying to high-income taxpayers in tax years beginning after Dec. 31, 2012).
Gold’s 12% annual pretax return over the past decade declines to less than 10% on an after-tax basis, but if the gold investment had been classified as a capital asset and taxed at a 15% capital gains rate, the after-tax return would have been nearly 11%. To make matters worse, losses on collectibles are first used to reduce capital gains. Therefore, to maximize after-tax returns, a tax-efficient vehicle for gold investments becomes critical. One option is to use an individual retirement account (IRA). While gold initially was not allowed in IRAs, the most common forms of gold investments, with the exception of Krugerrands (South African gold coins), can be purchased within an IRA.
This article examines opportunities for gold investors to substantially increase their after-tax returns via an IRA. While the focus of this article is gold investing and taxation, the same analysis applies to other precious metals (e.g., silver, platinum, and palladium) that are classified as collectibles.
A brief history of investing in gold and typical investment vehicles
While it is a popular investment today, gold ownership was restricted for years. President Franklin D. Roosevelt signed Executive Order 6102 in 1933, making it illegal to own more than a small amount of gold coins and bullion. The restriction was meant to curtail gold hoarding, which under the monetary gold standard was believed to be stifling economic growth, and lasted for more than 40 years before being lifted in 1975. Initially, investment options were limited to a few gold bars and coins. Today’s gold investment can take many forms—some examples are listed in Exhibit 1.
Gold coins and bullion bars
Gold coins and bullion bars often come to mind when thinking of investing in gold. One benefit of coins is that the reputation of the issuing country provides confidence in the accuracy of the coins’ purity and weight. While gold coins can vary in fineness among countries, coins typically contain one troy ounce of gold, or about 1.1 U.S. ounces. The spot price is the cost of one troy ounce of gold on the major world commodities markets. The difference between the purchase price and the selling price is the spread, or markup, that sellers take as profit. There is also a cost for storing physical gold. A small safe deposit box, which is adequate for most gold investors, ranges from $30 to $70 annually. The annual fee charged by brokers ranges from 0.5% to 1% of the value and typically includes insurance against theft or loss.
Gold bars are an alternative to gold coins. There are a number of gold bar issuers, but Credit Suisse is the most recognized. Markups on gold bars are typically lower than on country-specific gold coins, but both are collectibles for tax purposes.
Physical gold ETFs and closed-end funds
Gold exchange-traded funds (ETFs) provide an alternative to purchasing gold bullion and trade like shares of stock. Each ETF share represents an amount of physical gold, typically one-tenth of an ounce. ETFs allow investors the convenience of buying and selling gold just as they buy and sell common stock, with low transaction costs. Another advantage of gold ETFs is that investors are not responsible for storing the gold, although most ETFs charge an annual fee ranging from 0.25% to 0.4%. Like physical gold, gold ETFs are taxed as collectibles.
Closed-end funds (CEFs) are similar to gold ETFs and trade like a stock but are structured as trusts. CEF shares represent an undivided interest in the fund’s entire investment portfolio. Tax treatment of CEFs is more complex and presents both advantages and disadvantages. An advantage of non-U.S. CEFs is that long-term investments are taxed as LTCGs rather than as collectibles, which can increase after-tax returns. The disadvantage of non-U.S. CEFs is that federal tax reporting is more complex because they are passive foreign investment companies. Although beyond the scope of this article, the tax complexities can be mitigated by making a qualified electing fund election under Sec. 1295 on Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.
Nonphysical gold investments
Gold mining stocks, gold mutual funds, and gold mining ETFs provide investments in gold but with limited investments in physical gold bullion. These investments typically move in relation to gold prices but are also influenced by production and borrowing costs. In addition to simplified trading and low expenses, another advantage is that gains from investments held more than one year are taxed as LTCGs.
Gold exchange-traded notes (ETNs) are debt securities in which the rate of return is linked to an underlying gold index. A gold ETN does not physically own gold but at maturity yields a return equivalent to a gold investment. Because ETNs are secured only by the issuer, in an issuer’s bankruptcy the investors may receive little or no return of their investment. ETNs trade like stocks and benefit from LTCG treatment.
Gold futures contracts are an agreement to buy or sell—at a specified price, place, and time—a standard quality and quantity of gold. Futures contracts allow investors to leverage positions so that small swings in gold prices can lead to large profits or losses. The typical approach to investing in gold futures contracts is through purchasing gold futures ETFs or ETNs. For tax purposes, any gain or loss on a futures contract is treated as 60% LTCG and 40% STCG, colloquially known as the 60/40 rule. This provides an effective tax rate lower than the ordinary income rate but higher than the LTCG rate.
Taxes and investing in gold
Gains from investments in physical gold and physical gold ETFs outside an IRA are taxed as collectibles. If a gold investment is held more than one year, any gain is taxed at the same rate as ordinary income, except with a maximum tax rate of 28%.
IRAs and gold
When IRAs were first allowed in 1974, investments in collectibles were prohibited (Sec. 408(m)(1)). The prohibition’s intent was to reduce speculative risk-taking in retirement savings accounts. An exception to this rule introduced in 1986 allowed U.S. gold and silver coin investments. Beginning in 1998, the exception was expanded to include bullion that is 99.5% pure. In 2007, the IRS ruled that gold ETFs were not collectibles for IRA investment purposes (Letter Ruling 200732026). The one restriction that remains is that the IRA owner cannot have physical possession of the gold. This restriction is overcome by using an intermediary meeting the requirements of a trustee under Sec. 401(a) to hold the physical gold for a fee. Many gold IRA trustees charge a flat annual administration fee plus a flat fee for storage. Total annual fees range from $150 to $300 per year.
Like all IRA investments, gains from gold sold within an IRA are not taxed until cash is distributed to the taxpayer, and distributions are taxed at the taxpayer’s marginal tax rate. To illustrate the tax consequences of owning gold, Emma, a wealthy taxpayer, and Lucas, a median income taxpayer, provide an example.
Example. Emma is 60 years old and single and has $398,500 in annual taxable income. She is considering one of three options to invest $10,000 in gold: U.S. gold coins, a gold mutual fund, or a gold futures ETF. She is also considering whether to make her investment through a brokerage account, a Roth IRA, or a traditional IRA. Emma plans to hold the investment for 10 years, when her marginal tax rate will be 28% (and her modified adjusted gross income (MAGI) will be below the threshold amount for application of the net investment income tax under Sec. 1411(b)), and then sell, and in the case of the IRAs, distribute the proceeds.
Lucas is 60 years old and single and has $60,000 in annual taxable income. After retirement, he expects his taxable income to fall to within the 15% marginal rate on ordinary income. Lucas is considering the same gold investment choices as Emma and has the same plans for selling and distributing any proceeds. Exhibit 2 provides comparative information for Emma and Lucas.
For comparability, the before-tax contribution to the regular IRA is $10,000, while the contributions to the brokerage account and the Roth IRA are with after-tax dollars—$6,700 for Emma and $7,500 for Lucas.
The results for Emma and Lucas, shown in Exhibit 3, indicate that the after-tax returns of gold investments in a traditional IRA dramatically exceed those of gold investments in a brokerage account or a Roth IRA. Lucas’s annualized after-tax return increases by more than two percentage points by using a traditional IRA for his gold mutual fund investment and more than three percentage points over a brokerage account by using a traditional IRA for his investment in gold coins. For Emma, the results are even more dramatic. She gains more than 3.2 percentage points of annualized after-tax return by using a traditional IRA instead of a brokerage account for her gold mutual fund investment and more than 4.2 percentage points of annualized after-tax return for her investment in gold coins.
The 3.8% net investment income tax may apply to gains on gold from the brokerage account for taxpayers with higher MAGIs than in these examples. However, under Sec. 1411(c)(5), net investment income does not include distributions from a Roth or traditional IRA (or other specified qualified plans)—another reason for higher-income taxpayers to favor an IRA as a gold investment vehicle.
It is also important to note the differences in after-tax returns between the gold investment types held in a brokerage account. The annualized after-tax return on the gold coins is the lowest—about a percentage point lower than the gold mutual fund, which receives LTCG treatment. The example assumes that the costs and fees for buying, owning, and selling gold coins, gold mutual funds, and gold futures ETFs are the same. However, the total costs of owning gold vary widely among investment types and reduce after-tax returns. When buying gold, taxpayers should carefully compare annual costs, including annual maintenance fees, storage charges, buying costs, and selling costs, before selecting the investment.
Brightening gold’s luster
When gold increases in value and provides gains, robust before-tax returns might not translate into robust after-tax returns. Purchasing physical gold coins, bullion, or ETFs provides direct exposure to gold, but the collectibles tax treatment imposes a much higher tax rate. With some planning, investors can keep more of their gold returns by investing in gold that receives LTCG treatment or by placing the investment in an IRA. While secondary gold investments such as gold mining stocks, mutual funds, ETFs, or ETNs may yield lower before-tax returns, the after-tax returns may be more attractive. Alternatively, a physical gold CEF is a direct gold investment but has the benefit of taxation at LTCG rates.
While gold remains a popular investment, recent price declines have diminished the shine. The focus of this article has been on gains, but investors should also consider the consequences of a loss. Gold and all collectibles have the ultimate disadvantage of gains being taxed at the higher collectibles tax rate, with losses being first used to offset capital gains, which may be taxed at the lower LTCG rates. An individual taxpayer’s mix of investment gains and losses, risk profile, and success in investing ultimately determines the results, but a little tax planning can certainly increase gold’s luster.
After-tax returns on gold held as a long-term investment depend on, among other things, whether gains are subject to long-term capital gains tax treatment or are subject to the higher maximum collectibles rate. The latter applies generally to physical gold, such as coins and bullion. Purchases of physical gold may also entail storage and insurance costs.
Most gold investments can be held in an individual retirement account (IRA), which can increase after-tax returns significantly. Trustees of an IRA investing in gold may charge flat fees for storage and administration.
Whether through a brokerage account or via a Roth or traditional IRA, individuals may also invest in gold indirectly through a variety of funds, gold mining corporation stocks, and other vehicles, including exchange-traded funds (ETFs) and exchange-traded notes. Gains from stocks, mutual funds, and gold mining ETFs held more than one year are taxed as long-term capital gains.
Comparisons of hypothetical taxpayers generally indicate a significantly higher after-tax rate of return for any form of gold held in a traditional IRA than in a brokerage account and slightly higher than in a Roth IRA. For brokerage accounts, a gold mutual fund investment may be more likely to provide a higher after-tax return than gold coins or a gold futures ETF.
Steven H. Smith (email@example.com) is an assistant professor of accounting, and Ron Singleton (firstname.lastname@example.org) is a professor of accounting, both at Western Washington University in Bellingham, Wash.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at email@example.com or 919-402-4434.
- Client Tax Planning Resource, 2014 (#PCN1401W, Microsoft Word download; #PCN1401D, PDF)
- The IRA Distribution Rules: IRS Compliance and Audit Issues (#PPF1402P, paperback; #PPF1402E, ebook)
- Managing Your Tax Season (#PTX1402P, paperback; #PTX1402E, ebook)
- 2014 Tax Return Workshop (#735229, text)
- 2014 Corporate Tax Videocourse and Workshop (#112645, DVD w/manual; #735219, text)
- 2014 Individual Tax Return Videocourse (#113635, DVD w/manual)
- Investments (#757500013, text; #757501013, CD-ROM; #757502013, DVD)
- Tax Efficient Investing Seminar, Jan. 18, Las Vegas
- Advanced Personal Financial Planning Conference, Jan. 19–21, Las Vegas
For more information or to make a purchase or register, go to cpa2biz.com or call the Institute at 888-777-7077.
The Tax Adviser and Tax Section
The Tax Adviser is available at a reduced subscription price to members of the Tax Section, which provides tools, technologies, and peer interaction to CPAs with tax practices. More than 23,000 CPAs are Tax Section members. The Section keeps members up to date on tax legislative and regulatory developments. Visit the Tax Center at aicpa.org/tax. The current issue of The Tax Adviser is available at thetaxadviser.com.
PFP Member Section and PFS credential
Membership in the Personal Financial Planning (PFP) Section provides access to specialized resources in the area of personal financial planning, including complimentary access to Forefield Advisor. Visit the PFP Center at aicpa.org/PFP. Members with a specialization in personal financial planning may be interested in applying for the Personal Financial Specialist (PFS) credential. Information about the PFS credential is available at aicpa.org/PFS.