When you think of the word ‘gold’, what images come to mind? Images of riches, grandeur, and wealth perhaps?
Having been used as a form of currency for thousands of years, it is not surprising that the mention of the word gold can conjure up such images. Even today in the 21st century, in an age where even paper currency is becoming ever less common as digital transactions dominate the economy, gold still has its place.
In today’s article, we will be answering these frequently asked questions:
- Why should an investor add gold to his or her portfolio?
- What are some common methods of investing in gold?
- What is the best method of gold investing?
Why should an investor add gold to his or her portfolio?
Of course, in the modern economy of today, gold is no longer the be-all-end-all it once was. Despite that, gold continues to be a highly popular investment and offers the 21st century investor several powerful benefits. These benefits can be briefly summarized as below:
Gold is a store of value, making it a safe haven investment and a strong hedge.
Most of the world today, including the United States, operate using a fiat currency, meaning that the value of the currency is not backed up by any physical commodity (gold was previously used). As such, the money supply can and is easily manipulated, and while it is usually done with the intention of economic benefit, it can also lead to consequences such as a devalued currency and higher inflation. Gold tends to rise in such occasions, functioning as a hedge. Further, stocks and bonds can and have been entirely devalued; gold on the other hand, will never be worth zero.
Gold is lowly or negatively correlated with stocks and bonds, providing portfolio diversification.
Why all the hype about diversified portfolios? Well, the concept behind portfolio diversification is a portfolio where the total risk of the entire portfolio is less than the risk of the sum of its components. To create such a portfolio, its component parts should not be highly correlated with each other. Historically, gold has been either lowly correlated (typically remaining below the 40% threshold) with stocks and bonds, or negatively correlated, particularly during periods of economic recession.
Good historical returns over the long-term.
Every investor knows from reading the news that since its peak in 2011, sentiment has been ‘doom and gloom’ on gold. No doubt prices have been volatile and generally heading downward over the past few years, but did you know that over a 10-year period (as at Dec 2015), average annual returns on gold was 5.71%? This is significantly above yields on historically ‘safe’ assets such as 10-year US Treasuries.
If you would like to see a detailed elaboration of the above points, please take a look at our guide ‘Why Invest in Gold?’. We break down each point with detailed facts, figures, and charts.
What are some common methods of investing in gold?
For the typical investor, there are four main methods of investing in gold. They are as follows:
1. Gold Coins and Bullion
This is the simple buying of physical gold coins and bullion. Popular gold coins are American Eagle and American Buffalo coins, while gold bullion bars should be fabricated by the NYMEX, COMEX, or an ISO9000 approved refiner. Generally there are two options for purchasing physical gold, either buying the gold directly and storing it in a safe deposit box with a broker, or through setting up a Gold Backed IRA, which is a self-directed IRA in which the funds are used to purchase physical gold. In the latter case, note that IRS regulations prevent the account owner from physically possessing the gold, which would have to be stored with the Gold IRA custodian. Further, while physical gold is taxed as collectibles, gold owned through an IRA is not.
2. Gold Exchange Traded Funds (“ETFs”)
In an ETF, the fund owns the gold and the investor purchases shares in the ETF, with each share typically representing a tenth of an ounce of gold. If the demand for shares is higher than the ETF’s stock of gold, it must purchase more physical gold. Conversely, if an investor wants to redeem his shares and there are no buyers for said shares, the ETF must then sell the gold equivalent. While the investor does not hold the physical gold, the IRS nonetheless taxes ETFs as collectibles; note than while an IRA can be used to purchase shares in gold ETFs, they are still nonetheless still taxed as collectibles.
3. Gold Exchange Traded Notes (“ETNs”)
ETNs are debt instruments that track an index. Unlike ETFs, the ETNs do not physically own the gold, but rather upon maturity of the ETN, the yield would be equivalent to a gold investment. Basically, ETNS allow an investor to replicate playing the futures market without having to purchase contracts on the COMEX. Because they trade like stocks, they are taxed as such.
4. Gold Miner Stocks
This is the most indirect way to own gold. This of course would require additional analysis on the investor’s part, no different than when making the choice to invest in specific stocks (as opposed to investing in the equity market as a whole, e.g. through an index that tracks the S&P 500).
What is the best method of gold investing?
Now that we’ve clarified the four main methods that an investor can add gold exposure to his or her portfolio, you may be wondering which method of gold investing is ideal for you.
While investors should do their due diligence on each of the methods shown, the Gold IRA, has in our opinion demonstrated some clear benefits over the rest for the following reasons:
Investors Actually Own High Grade Physical Gold
Gold ETFs, ETNs, and gold miner stocks are all indirect methods of gold investment. As such, they do not get the full benefits of gold investment such as hedging and portfolio diversification. While in ETFs each share is ostensibly directly tied to physical gold owned by the ETF, unlike direct physical gold ownership, the ETF investor may have issues when it comes to redemption, as ETFs, as with all fund would impose its own withdrawal and redemption conditions (you may refer to page 10 of the prospectus of one of the most popular Gold ETFs, SPDR Gold Trust here). There is also no regulation covering the quality and finesse of the gold stored by the ETFs, unlike in Gold IRAs, in which the IRS mandates that gold owned through such IRAs must meet certain fineness requirements.
When it comes to Gold ETNs, it is equivalent to playing the futures market; i.e. there is no principal protection. Hence, it is possible to for an investor to lose the entire investment amount. Gold mining stocks, being equities, are inherently risky. Further, as we have noted above, choosing the right gold mining company can be difficult and tedious, as important factors such as production, reserve growth, production costs, phase of exploration, etc. can vary wildly from company to company; in that sense picking the right gold mining stock can be almost like playing the lottery: highly risky with a small chance of return.
Increased after-tax returns due to favorable tax treatment
First, we have to understand the different type of tax treatments applicable to gold. Due to the IRS’ classification of precious metals as collectibles, gains on such investments held for less than one year will be taxed as ordinary income, which is the same treatment as short-term capital gains. On the other hand, gains on collectibles held over one year are taxed ordinary income except that the maximum collectibles tax rate of 28% is applied. In comparison, the long-term capital gains tax rate varies from 15 – 20%.
On the other hand, gold invested through a Gold IRA is taxed at the taxpayer’s marginal tax rate, as opposed to the maximum collectibles tax rate of 28%. Consider a hypothetical case from the Journal of Accountancy about two fictional tax payers, Emma and Lucas, each wanting to invest $10,000 in gold and are considering US gold coins, a gold mutual fund, or gold ETF. Further, they are also deciding whether to make the investment through a brokerage account, or a traditional or Roth Gold IRA. Emma is in a higher tax bracket than Lucas, and thus has different marginal tax rates. The table below summarizes their comparative tax rates:
YI: The before-tax contribution to the regular IRA is $10,000, while contributions to the brokerage account and the Roth IRA are with after-tax dollars, translating to $6,700 for Emma and $7,500 for Lucas.
What are the after-tax returns to Emma and Lucas from each method of investment? The difference between each method may surprise you.
As you can see, even though both Emma and Lucas have very different marginal tax rates, they both receive the highest after-tax returns from investing in gold via an IRA, with Emma enjoying a 4.23% increase in returns over a brokerage, and Lucas enjoying a 3.09% increased return.
Source: refer to the full tax analysis on the various methods of gold investments at Journal of Accountancy.
Conclusion
Investing in gold is an increasingly popular choice for the modern investor as gold can offer many benefits to an investor’s portfolio. While there are various methods of gold investment available to the investor today, gold IRA investing has demonstrated some distinct benefits compared to the rest. Not only does it allow the ownership of physical gold, the investor can be ensured of the quality of said gold due to IRS regulations. Further, gold IRA investing also allows preferable tax treatments over other methods as shown above. With that being said, it is important that investors do their own research before making any decisions. We hope that this article has provided you with the knowledge required to better serve you in making the right investment decision for your needs.
