Reconsider Taxable Retirement Accounts

Physician's Money Digest, November30 2003, Volume 10, Issue 22

If you participate in a 401(k) plan or similaremployer-sponsored retirement program, youmay be able to save and defer income taxes onup to $13,000 in 2004. In addition, workers age50 and older may be able to set aside as much as$16,000 in their plans. Before you celebrate contributionincreases, however, consider the tax climate.

For years, contributing as much as possible to tax-deferredretirement accounts has been an appealingoption for many investors. However, the current taxclimate may prompt you to reconsider whether allyour retirement contributions should be going intotax-deferred retirement accounts, or whether taxableaccounts may offer advantages.

Taxable Considerations

When you decide where to put your retirementsavings, you also may be deciding what kind of taxesyou'll pay. Distributions from traditional IRAs will betaxed as ordinary income. If they are withdrawn priorto age 59 1/2, an investor may be subject to a 10% federaltax penalty. Contributions and earnings in anemployer-sponsored plan will be taxed at ordinaryincome tax rates when you withdraw them, regardlessof whether they came from interest income, capitalgains, dividends, or your deferred salary.

On the other hand, because of the 2003 tax law,the treatment of any earnings in taxable accounts willvary depending on how they were earned. Long-termcapital gains from stocks and bonds held more than 1year are now taxed at 15% for most people, and qualified corporate dividends will also be taxed at a maximum15% rate. Interest income and short-term capital gainswill continue to be taxed at ordinary income tax rates.

There are many variables when it comes to investingfor retirement, but 2 elements you can control arehow much you save and what type of account youuse. By investing solely in a tax-deferred plan, you willnot be able to take advantage of the new lower taxrates on capital gains and dividends. Of course,whether you should take advantage of these recent taxchanges will depend on your personal circumstances.

Taxed vs Tax-deferred

If you're interested in taking advantage of thelower tax rates on capital gains and dividends butaren't sure how to divide your retirement contributionsbetween taxable and tax-deferred accounts, considerthe following factors:

  • You typically pay income taxes on earnings intaxable accounts in the year that they were earned.
  • When your current tax burden is high, perhapsbecause of a large income and relatively few deductions,it may be to your advantage to defer any taxesthat you can.
  • When trying to predict whether your tax bracketwill be higher or lower in retirement, rememberthat in the future you may not qualify for many of thetax deductions that you currently use. For example,the longer you make mortgage payments, the loweryour interest deduction may be. And by the time youretire, your children may be grown, eliminating youruse of child tax credits or head-of-household status.
  • The lower tax rates on long-term capital gainsand qualified dividends are set to expire after 2008.No one can predict whether Congress will extendthese provisions.
  • Unlike employer-sponsored retirement plans,there is no legal limit on how much you can invest intaxable accounts.

The American tax landscape is a little confusingright now. Understanding how it applies to your particularfinancial situation may help to make your taxplanning more efficient.

Mark Scribner is a financial consultant atLinsco/Private Ledger. He welcomes questions orcomments at mark.scribner@lpl.com.