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.
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 If they are withdrawn priorto age 59 1/2, an investor may be subject to a 10% federaltax penalty.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:
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 firstname.lastname@example.org.