Why IRA and keogh plans should avoid growth stocks

This paper explores the effect of taxing personal income from common stocks on the return of equity portfolios held by mutual funds under IRA or Keogh plans. The expected rate of return earned by a tax‐sheltered fund on any given stock is inversely related to the stock's per‐share growth rate. The explanation for this effect does not rely on the standard assumption that growth decreases the effective rate of taxation. Rather, this effect holds despite heavier taxation of growth stocks because of the incomplete manner in which the return is sheltered. The implication of this finding for the optimal portfolio selection policy of tax‐sheltered equity funds is inconsistent with evidence showing that such funds tend to concentrate in growth stocks. A second issue examined is the use of IRA and Keogh plans as a temporary tax shelter. Under the present 10‐percent penalty on premature distribution, the critical investment period may be as short as two to three years. This finding indicates the usefulness of these plans as a general investment tool.