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| The Basics | How the tax cut changes your retirement planning
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Lower rates on dividends and capital gains change some of the traditional strategies when it comes to 401(k)s and IRAs. Annuities werent looking good before; now theyre positively radioactive.
By Liz Pulliam Weston
The new tax law didnt create any new ways to save for retirement, but it did change the rules for some time-tested investment strategies.
For one thing, the Jobs and Growth Tax Relief Reconciliation Act of 2003 makes saving in taxable accounts considerably more attractive. Dividends and long-term capital gains (on investments held 12 months or more) are now taxed at a top rate of 15%, down from the previous maximums of 20% for capital gains and 38.6% for dividends.
The rate drops to 5% for singles with taxable income under $28,400 and for marrieds with taxable income under $56,800. Theres even a bonus waiting for these lowest-income taxpayers: no tax on capital gains and dividends for one year, in 2008 (assuming Congress doesnt extend the new round of tax cuts).
When the penalty for being in a taxable account goes down (by reducing tax rates), said Mark A. Luscombe, principal analyst for tax research firm CCH Inc., that makes them a little more attractive relative to tax-deferred accounts.
Most retirement accounts require you to pay regular income taxes on withdrawals. You also typically face penalties for tapping your money early -- something you dont have to worry about with a taxable account.
Does that mean you should abandon your 401(k), 403(b), IRA or annuity? Heres the analysis, courtesy of tax and retirement experts from across the country.
401(k) and 403(b) plans
Every time tax rates get cut, these retirement accounts lose a little of their sparkle. Thats because the break you receive for contributing to them shrinks along with your tax bracket.
Theres a little less bang for your buck in every tax bracket, said Brett Hammond, director of portfolio studies for TIAA-CREF.
The change is most dramatic for married couples who used to be in the 27% bracket but who are now in the expanded 15% bracket (taxable income of $56,800 and below). They used to save up to 27 cents in taxes for every dollar contributed to a workplace retirement plan, but now the break has shrunk to 15 cents.
Now add in the uncertainty of future tax rates. If you expect to be in a higher tax bracket in retirement (because your income will rise over time, your investments will pay off or Congress will change the tax system again) you may be better off paying todays lower taxes rather than waiting to pay higher taxes in the future. That would involve investing in a taxable rather than a tax-deferred account.
Most people shouldnt stop their workplace retirement contributions, though. For one thing, a tax break in hand is usually worth two in the theoretical or future bush. Plus:
- You dont want to give up the free money you get from any employer match.
- Your contributions to a 401(k) or 403(b) reduce your adjusted gross income. That means you may qualify for other tax breaks that could be out of reach with a higher AGI. If youre single, for example, you begin to lose the ability to deduct student loan interest when your AGI exceeds $50,000. (You cant deduct it at all if your income exceeds $65,000.)
- You probably need the discipline of regular payroll deductions if youre going to save much for retirement. (The penalties for early withdrawal also should help you keep your mitts off your nest egg, so that you dont spend it before you even get to retirement.)
The strategy: For most folks, it still makes sense to contribute the amount necessary to get the full company match. Then, contribute up to $3,000 a year to a Roth IRA. If you can save even more and expect to be in a higher tax bracket in retirement, you can consider a taxable account for your additional investments. But do the math first to make sure youre not losing valuable deductions because of a higher AGI. If you dont want to gamble, make your extra contributions to your workplace retirement plans and enjoy the tax break, even if it is a little smaller than in the past.
Individual retirement accounts
The Roth IRA still beats a non-deductible IRA or a taxable account. In all three cases, theres no tax break for contributions. But when the money comes out of a Roth in retirement, its completely tax free.
How about if you have a choice between a Roth and a deductible IRA? Again, lower tax rates lessen the appeal of the deduction, and those who expect to be in the same or higher tax bracket in the future might want to gamble by contributing to a Roth instead. (Roth IRAs also have the benefit of more flexibility: Unlike IRAs, you can always withdraw your contributions without penalty and youre not required to make withdrawals in retirement.)
Annuities
Ouch. Sales of deferred variable annuities were already suffering because of the lousy stock market and previous tax cuts. Insurers complain that the new tax rate for dividends and the further reduction in the capital-gains tax rate will hurt sales even more.
They (annuities) really have lost their luster, said Bob D. Scharin, editor of Warren, Gorham & Lamont/RIA's Practical Tax Strategies, a monthly journal for tax professionals. Theres even less reason to invest in them now.
Heres why: Earnings in annuities grow tax-deferred, but theyre taxed at regular income tax rates on withdrawal -- up to 35% currently. That compares with the 15% capital-gains and dividend rates you would pay on a comparable long-term investment in stocks. Insurers are fighting for more favorable tax treatment for annuities, but so far without success.
Annuities also tend to have surrender fees if you bail out early and higher expenses than comparable investments that dont have the death benefit provided by the insurance wrapper. Those expenses, combined with the wider gap between capital gains and income tax rates, mean investors need to hold low-cost annuities for at least 20 years to break even. Thats according to calculations by the folks at TIAA-CREF, the worlds largest pension fund manager and an annuity provider.
However, you might choose annuities for other reasons. The death benefit guarantees your heirs will receive at least the same amount as you invested, even if you die when the market is in a swoon. If youre an active trader and dont hold your stocks for at least a year, you also may want an annuitys tax-deferral feature because you wont qualify for long-term capital gains rates anyway.
Where to hold what
Back when capital gains rates were higher and dividends were taxed as income, financial planners and tax experts had enormous fun fighting about how to divide investments between taxable and tax-deferred accounts.
They wrote long, formula-filled papers for professional journals proving that bonds should be held in tax-deferred accounts and stocks in taxable accounts -- or vice versa.
Congress just made the issue somewhat clearer, says Steve Norwitz, a spokesman for T. Rowe Price and one of the authors of those long tomes. (He argued, rather convincingly, for the stocks-in-tax-deferred-accounts side.)
Bonds, which generate interest that would be taxed at regular income tax rates, are typically better off held in your tax-deferred accounts, while the new capital gains and dividend rates mean stocks held for the long term should do better in taxable accounts.
Should is the operative word. The outcome depends on many variables, including the relative future performance of stocks and bonds, how long you plan to invest, your tax rate when you withdraw the money and, as always, what Congress may do to change tax rates in the future. If you decide to alter how you divvy up your investments, youre probably better off doing so with new money, Norwitz said, rather than rejiggering your whole portfolio and perhaps incurring more taxes.
Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money. She also answers reader questions in the Your Money message board.
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