Investigate Those Tax-deductible Plans

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Physician's Money Digest, November15 2004, Volume 11, Issue 21

I've often been asked whether it makessense to invest in tax-deductible retirementplans or if it is preferable to paythe taxes now and invest personally. Thiswould allow someone to avoid a retirementtax trap whereby all distributionsfrom retirement accounts are subject toincome taxes. Some advisors also advancethe argument that income tax rates havegone down, so the tax deduction for contributionsto retirement accounts areworth less. Over the past few years, themaximum federal income tax rate hasdropped from 39.6% to 35%.

Tax-deductible Plans

Long-term capital gains rates havedeclined, reducing the taxes on gains fromthe sale of personal investments, makingthem more valuable. Tax rates on long-termcapital gains have dropped from 20%to 15%. Tax rates on corporate dividendshave been reduced, making personalinvestments in US corporations moreattractive. Corporate dividends were taxedas ordinary income, but are now taxed at amaximum federal rate of 15%.

All of the above pronouncements arecorrect, but does this necessarily lead to theconclusion that tax-deductible plans are nolonger advisable? Studies have found thatin all but the most extreme cases (eg, a verylow tax bracket during contribution yearsand a very high tax bracket during retirementyears), you significantly benefit frominvesting in tax-deductible retirementaccounts. The reason is because of the differencebetween your marginal tax rate ascontributions are made during earningsyears, and your effective tax rate as fundsare withdrawn during retirement years.

Tax Advantage

Let's look at an example of this concept.Assume a married couple has a grossincome of $100,000. After the standarddeduction and personal exemptions, theyhave taxable income of $84,100, whichputs them in a marginal tax rate of 25%.This marginal tax rate means that if theyearned an additional $1, they would owe$0.25 in federal taxes on that dollar. Thisalso means that if, instead of earning anadditional $1, they invested $1 in a tax-deductibleIRA, they would receive a $0.25tax refund. Thus, they are rewarded fortheir contribution by a tax deduction thatyields a 25% tax benefit.

At retirement, this couple will withdraw$100,000 per year from their IRAaccount. After the standard deduction andpersonal exemptions, they owe federaltaxes of $14,320 or an effective tax rate ofonly 14.3%. In effect, this couple receiveda tax deduction of 25% for their contributionsbut only paid 14.3% of taxes on theirwithdrawals. If you compare the actualdollars ahead for a 50-year-old couple contributing$16,000 per year to their 401(k)plan vs paying the tax on the $16,000 andinvesting the remaining balance personallyfor a 15-year period at 10%, the retirementaccount would be tens of thousandsof dollars ahead on an after-tax basis(approximately $436,000 vs $351,000).

Based on multiple scenarios, investingin tax-deductible retirement accountsyields better long-term results bothbefore and after taking taxes into account.For your long-term investmentstrategy, remain focused on the power oftax-deductible retirement accounts.

Stewart H. Welch III, CFP®, AEP,

is the founder of The Welch

Group, LLC, which specializes in

providing fee-only wealth management

services to affluent retirees

and health care professionals

throughout the United States. He is the

coauthor of J.K. Lasser's New Rules for Estate

and Tax Planning (John Wiley & Sons, Inc;

2001). He welcomes questions or comments at

800-709-7100 or visit www.welchgroup.com.

This article was reprinted with permission from

the Birmingham Post Herald.